Steps for normalization
Besides reducing the federal funds rate to near zero levels, the Fed also embarked on three rounds of quantitative easing (or QE). QE involves purchasing Treasuries and agency-backed securities on the open market. QE injected market liquidity after the financial crisis.
It kept interest rates low in the U.S. economy—including Treasuries (or TLT), corporate high-yield bonds (HYG), and real estate mortgages (or IYR). It also ensured that corporate borrowing touched record highs. Corporates (SPY) (QQQ) borrowed to take advantage of low rates—refer to Part 4 in this series.
Now, the Fed is looking to decrease the size of its bloated balance sheet—estimated at ~$4.5 trillion as of September 17.
Reinvestment of MBS and Treasuries
To reduce market volatility, the Fed disclosed its current plans for balance sheet normalization at the end of its September Federal Open Market Committee (or FOMC) meeting.
- Balance sheet normalization would be undertaken only after the federal funds rate increases
- Balance sheet normalization would be undertaken gradually. The pace of reinvesting maturing Treasury and agency-backed securities would be reduced, or stopped altogether. This would result in a gradually reduced assets level.
- The FOMC also doesn’t plan to sell any agency-backed securities as part of normalization. The FOMC would communicate any changes in selling intentions in advance.
- After the balance sheet has been scaled-down, the Fed’s assets would mainly consist of Treasuries.
At September’s FOMC, two members preferred that the FOMC adopt a more flexible approach to the sale of agency mortgage-backed securities. This would reduce the size of the Fed’s balance sheet. It would also “limit distortions in the allocation of credit” across different economic sectors.
Currently, mortgage rates are at artificial lows. This was caused by the price support for mortgage-backed securities (or MBS) provided by the Fed. If the Fed dumped its holdings of MBS in the market, mortgage rates would rise. This would put more pressure on the housing market.
Some participants also favored an earlier end to reinvesting the maturing Treasuries and MBS in its portfolio. An earlier end to reinvesting maturing securities would see higher yields for Treasuries (TLT) and MBS. This would translate to the overall bond (BND) and real estate (or IYR) markets.
Size of the Fed’s reduced balance sheet
In the long run, the Fed plans to hold no more securities than necessary to carry out its monetary policy mandate. According to Janet Yellen, speaking at the FOMC press conference after the meeting, “it would take until the end of the decade to achieve” normal balance sheet levels.
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