Reducing the Fed Balance Sheet: What Can Investors Expect Next?

Reducing the Fed’s Balance Sheet:
What Can Investors Expect Next?

In June 2017, the Federal Reserve Open Market Committee indicated that, provided the economy continues to perform as anticipated, the Fed would soon begin implementing balance sheet normalization. The term “balance sheet normalization” means gradually reducing the Federal Reserve’s securities holdings by paring back principal payment reinvestments.

While beginning the process of balance sheet normalization indicates the Fed believes the economy has found its footing after the Global Financial Crisis (GFC), the process is not without risks the Fed wants to minimize.

The chart below shows that the Federal Reserve currently holds a significant amount of Treasury and Mortgage Backed securities. It has maintained these levels since 2014. The Fed purchases and sells Treasury securities as part of its normal open market operations, but since the GFC, the Fed increased its purchases of Treasury securities.

These increased purchases were part of the Fed’s “quantitative easing” or QE program, which it instituted in 2009 as a response to the GFC. The QE program promoted increased lending by financial institutions at a time when the U.S. economy needed it most. Because financial institutions had more liquidity, they could keep interest rates low and lend more, which stimulated the economy.

The Fed will determine the timing and pace of normalization, provided economic growth is as expected. The Fed intends to keep the federal funds rate in the target range by adjusting the interest it pays on excess reserve balances. During normalization, the Fed will not do a large sale of existing securities, but most likely plans to reduce the balance sheet in a gradual and predictable manner by phasing out reinvestments.

The Fed also does not expect to sell its holdings of agency mortgage backed securities as part of the normalization process. The Committee expects to hold securities in the amount that they would normally need to perform standard open market operations.

Once Normalization Begins, Will the Fed Face More Challenges?

The Fed’s timeline for selling the securities is flexible, but if it starts to do so in volumes that the market is not ready to absorb, market reaction could be negative. The Fed will likely try its best to telegraph its plans for the schedule and amounts it will reduce. This type of transparency would help investors become more comfortable with the process.

Another Challenge – The Fed’s Interest Rate Policy

The Fed has been raising short-term interest rates over the last couple of years, and as of now, plans to continue to raise them in the years to come. Raising rates and reducing longer securities may send mixed signals to investors.

It also could cause the yield curve to flatten or invert, which would be problematic for financial services firms that depend on the spread between short and long rates for their own profitability. It’s unclear how the Fed will handle this, but if it starts to normalize its balance sheet, the Fed may not raise rates as fast as it had planned.

These are just two of the several challenges faced by the Fed as they begin the normalization process. However, the start of balance sheet normalization could cheer investors, as it shows the economy has finally made the long road back from the GFC. Yellen and the Fed are thinking through these challenges as they make plans to take these next steps.

This is unprecedented, uncharted territory with global ramifications. The Fed will need to navigate challenges that may affect world markets in several ways as it begins the balance sheet normalization process. Segal Marco Advisors will continue to follow the situation and will provide timely updates as they unfold.

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