What the Fed’s Balance Sheet Run-Off Could Mean for the Bond Market

The minutes from the Federal Open Market Committee’s meeting, on the 14-15 December 2022, suggest that the Federal Reserve will turn to a balance sheet runoff, as well as interest rate rises. These moves suggest an intention to help curb inflationary pressure caused in part by low unemployment and a tight labour market.

A balance sheet run-off is when the size of the assets held in a portfolio decreases and can be done in a variety of ways, ranging from securities maturing or the selling of these assets. America’s central bank has seen a more than twofold increase in its balance sheet since early 2020 as a consequence of a vast bond-buying programme, attempting to stimulate the economy and lower borrowing costs due to the pandemic, leaving $9tn of assets under its control.

Initially, the $4 trillion of Treasury bonds and mortgage-backed securities purchased since the beginning of the pandemic were to help stabilise the economy by a process called quantitative easing (QE). This is where a central bank increases a country’s money supply by the purchase of assets, prompting banks to lend more despite low-interest rates and also causing a decrease in the yield of bonds. However, with inflation soaring it is now thought that this augmented balance sheet is keeping down long-term interest rates and the shrinking is needed to curb demand.

However, the markets were caught off guard. Well aware of the future increases in interest rates expected multiple times in 2022, and despite the Fed already announcing plans to withdraw the $120bn-a-month bond-buying programme as early as November, the sudden references to the balance sheet in the December meeting took the market by surprise. The Fed’s intention to further slim the balance sheet was further confirmed by Fed Chair Jerome Powell in a meeting with the senate on the 11th January 2022. The reasoning, he said, for the central role the balance sheet can play in stifling inflation is due to its flexibility in the uncertain times of Covid-19. Equally, he stressed the difficulty in solely using demand-side solutions (interest rates) to try and solve supply-side problems.

The precise details on when and what form this runoff will take are still unclear with Powell confirming that these are discussions for later meetings. What is clear from the minutes, however, is that this tightening of monetary policy will be much sharper than when it last needed to shrink its balance sheet in 2017, after the QE programme to stimulate the country after the 2007-2009 recession. The balance sheet decreased only $600 billion in a gradual process capped at $50 billion per month. However, this time around, the bank is likely to move faster due to a larger balance sheet, higher inflation and a more optimistic outlook for the economy, in contrast with the aftermath of the financial crash. Raphael Bostic, Atlanta Fed President, has even gone as far as suggesting reducing its holdings by $100 billion a month and withdrawing at least $1.5 trillion which he considers “excess liquidity.”

With the US owning at least one-fifth of Treasury Inflation Protected Securities (TIPS), this has made a considerable mark on the $22tn US Treasury market. This decreased their yields into the negative. However, with markets alerted to a potential cut to the balance sheet this week the yields of TIPS, known as real yields, soared to their highest level since April. Bond yields move inversely to price, and with an effective increase of supply by about $230 billion, the price of bonds has decreased. This will have further implications as a whole as real yields are pivotal to the backbone of financial markets as they are often used by investors to value assets such as real estate, stocks and bonds. Tech shares are especially sensitive to this rate and the market has already seen the Nasdaq fall ten per cent as a result. Although it has rebounded slightly since it has not recovered to its previous all-time high.

Until more details emerge about the Fed’s plans for the runoff, it will be too soon to evaluate the full impact. With such a large holding of Treasuries, the slimming of the balance sheet will be a real test of private demand.

Analyst: Edward Raftery

Sector Head: Edward Raftery

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