Mark Tranckino 2017-12-13 00:06:04
The Federal Reserve finally began unwinding its balance sheet in October, some four years after tapering the third phase of its balance sheet expansion. The first phase of quantitative easing dates back to 2008, when policy makers determined the home mortgage-induced recession required more than just targeting a 0 percent overnight rate. With multiple rounds of quantitative easing, the Fed balance sheet increased from $869 billion on Aug. 8, 2007, to its current size of approximately $4.3 trillion. For the last four years, since ending its expansion, the Fed has maintained its holdings of $2.5 trillion in Treasury securities and $1.8 trillion in mortgage-backed securities by reinvesting the principal rolling-off the portfolio. Now that the Great Recession appears safely behind us, the Federal Open Market Committee is continuing its effort to normalize monetary policy by gradually increasing the overnight target rate and gradually decreasing the unprecedented expansion of its balance sheet. In hindsight, the extraordinary easing of policy can be seen as a desperate attempt by the Fed to stabilize the financial crisis. Of course, the effectiveness of the program will long be debated. Some will argue that QE went on for too long, leading to over-inflated asset prices. But so far, the U.S. financial system seems to have survived a scare of historic proportions. So why isn’t the bond market selling off now that its biggest buyer is buying less? For starters, the Fed has carefully telegraphed its plan over the course of 2017 to avoid upsetting the financial markets. Preparation began last March when a statement from the FOMC indicated a “change to the committee’s reinvestment policy would likely be appropriate later this year.” In June, policy makers announced “the committee currently expects to begin implementing a balance sheet normalization program this year.” All of this was orchestrated to avoid a repeat of the “taper tantrum” of 2013. It was then that just a hint from Chairman Ben Bernanke that the Fed would wind down its purchases triggered a huge sell-off in bond prices. The 10-year Treasury yield rose by more than 100 basis points, touching 3 percent — a level not seen since, even during the recent “Trump bump.” Another contributor calming the markets is the very slow and measured approach the Fed is taking to unwind its position. Initially, the Fed plan allows $6 billion of Treasuries and $4 billion of mortgage-backed securities to mature without reinvesting the principal. These amounts will increase by $10 billion each quarter to a maximum of $50 billion. Current expectations are that the Fed will keep rolling-off proceeds until its balance sheet shrinks to about $2 trillion, a process that could take four or five years. Fed Chair Janet Yellen likes to say the process will be akin to “watching paint dry.” According to Fed officials, the long-run plan is to keep the balance sheet “appreciably below that seen in recent years, but larger than before the financial crisis.” The initial impact of quantitative tightening will be cushioned from the standpoint that the banks’ total reserves are unusually high. When the Fed purchases bonds from banks, it pays for them with newly created money by crediting the reserves banks hold at the Fed. These bank reserves become liabilities on the Fed’s balance sheet that correspond to those new assets. Bank reserves parked with the Fed soared as a result of quantitative easing. Currently, there is more than $2.3 trillion in reserves, of which some $2.2 trillion is in excess of what banks are required to hold at the Fed. In time, these reserves may fall to the point where banks may need to buy other liquid assets, such as Treasuries or mortgage-backed securities. This could ripple through markets, potentially reducing the impact of the Fed’s unwinding on long-term rates. Economic fundamentals suggest bond prices should fall as the central bank tightens, but bond prices are always a function of many variables. As such, investors should not automatically assume bond prices will move lower as the balance sheet reduction begins. In recent years, policy makers have been overly optimistic and overestimated their ability to return to a “normal rate environment.” Although the Fed has a timetable for gradually scaling back the reinvestment of principal maturing, it’s not a definitive schedule. Should the economy slow, or inflation wane, the Fed could reduce, or even terminate, the tapering. In fact, many investors believe the Fed will not deliver on its promises, as indicated by a recent survey from Bank of America that found just 5 percent of investors are positioned for higher rates. Navigating the unwinding of these unchartered waters will surely shape future policy as it relates to the merits of quantitative easing and could offer a road map for other central banks, especially the European Central Bank, that are preparing their own retreat. Mark Tranckino is senior vice president in the Capital Markets Group at Country Club Bank in Kansas City.
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