If you thought the Federal Reserve’s interest rate increases have been gradual, wait until you see what it has planned for its $4.5 trillion balance sheet.
The central bank looks likely to begin reducing its bond holdings at a glacial pace given how uncertain officials are about the impact on financial markets, monetary policy and the economy. The aim, according to New York Fed President William Dudley, is to ensure that the drawdown is “a very modest, minor event.”
“We want this very much to run in the background,” he said at the Bombay Stock Exchange in Mumbai on May 11. So “we’re going to do this in a very careful way that’s very much well-communicated to markets.”
That doesn’t mean there aren’t risks to a move that officials say could start later this year. Despite the central bank’s best intentions, it may still end up disrupting markets, especially for mortgage-backed bonds. It holds more than a quarter of U.S.-government backed mortgage-related debt.
“The balance sheet was a large positive for the financial markets” as it was being built up, said Jim Bianco, president of Chicago-based Bianco Research. “It’s going to be a drag on the markets and the economy” as it’s wound down.
Investors probably will get another glimpse into the Fed’s plans on May 24 when it releases the minutes of this month’s policy-making meeting. At that May 2-3 gathering, the central bank held interest rates steady while suggesting it remained on course for two more increases in 2017, after raising rates just three times in 18 months.
A number of Fed watchers, including Cornerstone Macro’s Roberto Perli, Jefferies’s Tom Simons and Wrightson ICAP’s Lou Crandall, expect policy makers to begin the balance sheet drawdown with monthly reductions of $20 billion, split evenly between mortgage-backed securities and Treasuries.
“Everyone has said they want to just dip their toe in the water” when they make their first move on the balance sheet, said Stephen Stanley, chief economist at Amherst Pierpont Securities, who also envisages a $20 billion monthly kick-off.
Others see Fed Chair Janet Yellen and her colleagues going even more gradually. Michael Feroli, chief U.S. economist at JPMorgan Chase & Co., forecasts the Fed will start with monthly cuts of $2 billion of MBS and $4 billion of Treasuries, and then increase the drawdowns by those same amounts at subsequent policy-making meetings.
Gennadiy Goldberg, senior U.S. rates strategist at TD Securities, also anticipates a leisurely beginning, with the Fed initially allowing 10% of each month’s maturities to roll off. It would then ramp that up gradually if markets responded calmly. Some $425.6 billion of the Fed’s $2.5 trillion inventory of Treasuries come due next year.
The argument for a slow start stems from the lack of clarity about the size and nature of the potential impact. While Fed officials are hopeful they can avoid a severe reaction, they admit they lack experience in managing a reduction in the balance sheet.
“We’ve never done this before,” Dudley said in Mumbai, adding that there’s “a lot of uncertainty” about how much the Fed’s asset purchases have depressed Treasury yields. While calculations of that impact range from about 50 to 100 basis points, “there is a pretty big confidence interval around any estimate that you come up with,” he said.
A research note released last month by three Fed staffers, for instance, found that the central bank’s inflated balance sheet was depressing 10-year Treasury yields by anywhere from about a half to 1.5 percentage points at the end of last year.
What’s more, it’s unclear how that maps into the overnight interbank interest rate that the Fed targets.
The traditional rule of thumb -- which Yellen alluded to in a Jan. 19 speech -- reckons that each basis-point change in the 10-year yield is equivalent to about a three-basis-point move in the central bank-controlled federal funds rate. That would imply that asset cuts that lifted yields by a half percentage point would correspond to a whopping six quarter-point interest-rate increases by the Fed.
Other central bank officials have suggested that the relationship between the two is closer to one-to-one when it comes to the balance sheet, an unconventional monetary policy tool not used in the past.
If that’s the case, the Fed should be able to follow through with its intention of raising rates three times next year even as it’s lowering its bond holdings, according to Krishna Guha, vice chairman of Evercore ISI.
The smaller balance sheet though may mean that the federal funds rate in the long run will settle at 2.5% to 2.75%, instead of the 3% equilibrium level central bankers currently envisage, Guha wrote in a May 10 note to clients. The central bank’s target range for its policy rate currently stands at 0.75% to 1%.
Perhaps the biggest uncertainty surrounding the drawdown is its effect on the housing market. The Fed owns $1.8 trillion in mortgage-backed securities and is a major buyer as it recycles the proceeds from its maturing holdings back into the market.
On average, the Fed reinvests about $30 billion per month into mortgage-backed debt, buying up about a quarter of new issues, according to Cornerstone Macro’s Perli.
“This could lead to a big disruption if the Fed’s not careful,” he said in May 12 video for clients. “The point is the Fed will be careful.”