On May 4, the Federal Open Market Committee is expected to announce a 50-basis-point (bp; 100 bps equal 1.00%)—0.50%—increase in its target for the federal funds rate. It’s also likely to announce it will start shrinking its balance sheet. What will the balance-sheet reduction look like, and what might it mean?
Lessons from last time
The last time the Federal Reserve (Fed) tried to shrink its balance sheet, it didn’t get very far. In October 2014, the Fed stopped expanding its balance sheet by buying just enough securities to replace those that were maturing. It hiked its target for the federal funds rate in December 2015 and said it would shrink its balance sheet only after rate hikes were well underway. In September 2017, the Fed announced it would start shrinking its balance sheet gradually.
Expanding the Fed’s balance sheet was called quantitative easing, so shrinking it was called quantitative tightening. In 2017, the Fed allowed its assets to mature, and it reinvested enough to hit a certain rate of balance-sheet reduction. The amount of reduction was called a balance-sheet reduction cap. Fed Governor Lael Brainard said she wanted the balance-sheet reduction to be like watching paint dry. It started that way, but after only two years and balance-sheet shrinkage from around $4.2 trillion to $3.6 trillion, the Fed had to reverse course. Something broke.
In mid-September 2019, overnight interest rates spiked higher. There was a large drop in bank reserves due to a corporate tax payment deadline and a large increase in U.S. Treasury security issuance. There were plenty of bank reserves in the system as a whole, but they weren’t distributed in a way that kept markets functioning properly. Since then, the Fed has implemented a few programs to help keep things like that from happening again—for example, the Standing Repo Facility was established in July 2021 to provide funds when necessary.
What the Fed has already said
What about this time? How low can the Fed go, and how fast can it get there? Only time—and market conditions—will tell how low the Fed’s balance sheet can go. But in terms of how fast, in the minutes from the March 15–16, 2022, meeting, we got a really good picture of what it might try to do:
“Participants generally agreed that monthly caps of about $60 billion for Treasury securities and about $35 billion for agency MBS [mortgage-backed securities] would likely be appropriate. Participants also generally agreed that the caps could be phased in over a period of three months or modestly longer if market conditions warrant.”
We believe a good base case is to think that the Fed will hike rates by 50 bps on May 4, announce it will start shrinking its balance sheet in June, and slowly ramp up the pace of balance-sheet reduction. The Fed might start with a $20 billion reduction of Treasuries in June, ratchet that up to $40 billion in July, and hit the longer-term run-rate of $60 billion monthly by August. It could use a similar pattern for phasing in the reduction of its agency MBS holdings.
How long can quantitative tightening run?
How sustainable is that pace of balance-sheet reduction? With MBS, a lot depends on prepayments. The principal payments alone will be unlikely to meet the $35 billion monthly target. Now that mortgage rates have risen, prepayments are likely to slow, so it will be interesting to see if the Fed needs to rethink its agency MBS reduction target or not.
The maturities of the Fed’s Treasury holdings are more predictable. For the first two years, the Fed should be able to allow the balance sheet to primarily shrink “naturally” through maturing securities. There are a few months early on when the Fed might have to choose to allow some of its Treasury bills to mature instead of reinvesting their full proceeds. For at least the first two years, though, it should be able to hit its balance-sheet reduction target by allowing its holdings of notes, bonds, floating-rate notes, and Treasury Inflation-Protected Securities (TIPS) to mature.
But what then? What about after June 2026, when the maturity profile reveals a gap between the target run-off and the total dollar amount of securities maturing? If the Fed wants to shrink its balance sheet to pre-COVID-19 levels, it might not be able to get there from here—at least not without selling securities.
What happens after two years and $2 trillion?
Here are three things we think the Fed would consider, in order of likelihood:
- Quit after two years and $2 trillion. After two years, the Fed’s balance sheet likely will be $2 trillion smaller than it is today, so maybe that’s good enough. In this scenario, the Fed could just reinvest any maturing securities in Treasury bills to gradually shift its portfolio back toward mostly Treasury bills.
- Shift to a natural run-off. Because maintaining a rapid pace of balance-sheet reduction could shift the Fed’s portfolio away from Treasury bills and toward longer-dated securities, the Fed could hold and roll its Treasury bills while allowing the other Treasury securities to naturally mature. The downside is that this approach would make the balance-sheet reduction more erratic.
- Calibrate the yield curve. To maintain a target pace of balance-sheet reduction, the Fed could be opportunistic about which maturities to sell. Some Fed officials have said they would like to see longer-term yields on Treasuries stay higher than shorter-term ones, so if the yield curve looks too flat, the Fed could sell longer-maturity bonds. If the yield curve looks fine, it could sell a combination of longer- and shorter-term bonds to try to avoid affecting the shape of the curve.
What approaches we like looking ahead
As we came into the year, we held two beliefs. First, 2022 would see more fixed income market volatility than we had experienced in 2021. Second, the economic cycle would continue to play out in a more accelerated manner than we’ve seen in the past. Those beliefs seem pretty well vindicated.
Markets have moved from pricing in an end-of-2022 federal funds rate of 0.76% at the beginning of 2022 to a 2.73% rate as of April 22. We think that’s a reasonable repricing of short-term yields. Looking forward, the short end of the yield curve—the portion from overnight to two years out—could see some material flattening as expectations of rate hikes become a reality.
The short end of the Treasury market has already repriced significantly, which may be good news for short-duration investors. Our preferred strategies were light on duration to avoid some of the most aggressive drawdowns on the short end. Now, our preferred approach is to move toward a more neutral position for short-duration strategies.
When thinking about what lies ahead for intermediate- to longer-duration strategies, the possibilities get trickier. Last year, there was a rather significant yield pickup going from the 2-year Treasury out to the 30-year Treasury. The difference in yield was 2.10%. As of April 24, the difference was 0.19%. The historical average is 1.67%, so last year, the curve may have been too steep while now it might be too flat. Planning on any sort of reversion to the average would imply there’s still some increase in longer-term yields ahead of us.
While we aren’t too keen on getting too much duration exposure, we are more favorably disposed toward credit risk compared with where we were at the beginning of 2022. Coming into this year, we thought credit spreads were too rich, meaning they were too narrow. Now that we’ve seen some spread widening as well as the level of yields rise, we don’t believe credit risk is cheap, but rather, that it’s probably closer to fairly valued.
We think the economy may be transitioning from mid-cycle to late-cycle. While we think there’s still time for the economic cycle to play out, current spread levels don’t seem to be pricing in much chance of a downturn. Hence, we prefer to reduce credit risk and move up in quality. Importantly, we have focused on diversified exposures as well.
How much action the Fed actually does relative to what it has said and what the market is pricing will depend on what financial conditions will warrant. The Fed has shifted its tune regularly, so if we see inflation moderate even a bit along with some economic softness as a result of high food, fuel, and financing costs, the Fed could change its tune once again. As a result, we don’t want to make very big calls on the next move on rates. We’d rather lean heavily on our credit analysts and the work they do in finding securities that have risks we think investors are adequately compensated to own.