The Federal Reserve’s (Fed) latest meeting may have seemed like an extension of the status quo. The central bank left interest rates unchanged and signaled it will stay on a path of gradual tightening as the year progresses.1 But earlier this year the Fed cracked open a Pandora’s box that hung over this meeting: The potential unwinding of its swollen $4.5 trillion balance sheet.
Minutes from its March meeting noted the Fed’s intention to start unwinding its balance sheet later this year.2 While the Fed may not have addressed the balance sheet at the meeting on Wednesday, investors are now waiting for more details on this massive undertaking that could unfold as the year progresses. The Fed is in uncharted territory, and unwinding its balance sheet has the potential to spook investors and the markets.3
Deflating a bloated balance sheet
The Fed began building its balance sheet during the financial crisis after near-zero interest rates failed to spur economic activity. The theory behind the Fed’s quantitative easing (QE) program was that large-scale asset purchases would increase the money supply and lead to economic growth.4 Given the upward trajectory of equity markets and continuing strengthening in the job market since the financial crisis, some may conclude the Fed has accomplished its mission, and it is time for the central bank to unwind its hulking balance sheet.
Source: Federal Reserve data, as of 4/24/2017
Conventional wisdom is that shrinking the balance sheet must be gradual process to minimize market impact.5 The Fed indicated in 2014 that it would taper in a “gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held” after the Fed Funds rate had normalized.6 However, the Fed has never specified what a “normal rate” looks like.
The method and pace for unwinding the balance sheet are of concern not only to the Fed but also to investors. As shown in the chart below, the Merrill Lynch Option Volatility Estimate (MOVE) Index, which tracks bond market volatility, is expressing trepidation about the normalization process.
Source: Bloomberg Finance L.P. , as of 4/19/2017
At the same time, a large portion of the Fed’s portfolio, as shown in the next chart, matures in the next two years.7 If the Fed proceeds with its balance sheet plans in a “gradual and predictable manner,” it is more likely to slowly phase out, but not completely cease, reinvestments to smooth out the tapering process.8
Source: Bloomberg Finance L.P., as of 4/20/2017
A worldwide tapering?
Adding another wrinkle to the situation is the fact that the Fed may not be alone in its efforts to unwind a bloated balance sheet. Central banks across the globe entered an era of unprecedented monetary expansion after the financial crisis, and the following chart captures the rate at which central banks in Japan, the Eurozone and the US increased their holdings. Today, central bank assets in these three countries are approaching $13 trillion.9
Source: Bloomberg Finance L.P., as of 4/20/2017
While it is difficult to anticipate the effects of synchronized monetary tightening across such large economies, the market has already experienced a sell-off of US Treasuries by one of the world’s largest economies. China sold $215 billion in Treasuries from November 2015 to November 2016.10 It then initiated a roughly $66 billion sell-off of US debt immediately following the presidential election11 in an attempt to prop up the yuan following a capital flight.12
However, China’s massive Treasury sales went fairly undetected by the markets and had only a small impact on Treasury yields as other big buyers stepped in. This should provide some peace of mind for investors that a large Treasury sell-off doesn’t always result in market chaos.
Source: US Treasury Data, Bloomberg Finance L.P., as of 4/20/2017
The Fed balance sheet may never be the same
There is much uncertainty as to how the Fed institutes its tapering. While the Fed may soon determine a course of action, implementation could be altered if President Trump decides not to re-nominate Fed Chair Janet Yellen when her term expires in 2018.
Regardless of Yellen’s fate or how the Fed chooses to unwind its balance sheet, we may never return to pre-crisis balance sheet levels. The liability side of the Fed’s balance sheet has grown in tandem with assets, and there is also more currency in circulation. The way the Fed manages interest rates has also evolved. Prior to 2008, the Fed would make adjustments on reserves from depository institutions to change interest rates. Now, it pays interest on the increased reserves to help manage interest rates.
Amid this very uncertain backdrop, a flight to quality could put downward pressure on yields. That means navigating the unwinding will require prudent duration risk management. Investors should be precise with their duration targets to ensure the relative yield/duration tradeoff is optimal, while keeping an eye on credit risk. Having an actively managed core could help investors manage these macro nuances.
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