Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

The Federal Reserve will almost certainly take steps to start reducing its $4.5 trillion balance sheet later this year.

The central bankers made that clear in the minutes from their May 2-3 meeting, which were released Wednesday. At first blush, this seems as if it would be bad for longer-term debt, which is yielding much less than it has historically in large part because of the Fed's post-crisis stimulus effort of purchasing the debt. If a huge buyer stops buying, that typically means that prices drop and yields climb.

But after the minutes were released, Treasury values rose and longer-term yields fell. 

No Fear
Investors bought long-term U.S. bonds, even as the Fed talked about shrinking its balance sheet
Source: Bloomberg

One interpretation is that traders aren't taking the Fed seriously. But another is that investors just received an unexpectedly concrete sense of the Fed's methodology for unwinding its balance sheet, and it clearly indicates moving at a glacial pace. Fed members said they favored a method that included allowing a certain amount of their holdings to pay down without reinvesting the proceeds.

The Fed would cap the amount of debt they'd allow to roll off at a certain level, and then would adjust that level every three months. Officials agreed they should provide additional details of the plan “soon."

Before these meeting minutes, traders weren't sure what to expect from the Fed's plan to shrink its gigantic pile of debt. It seemed conceivable that the central bank would embark on an unpredictable path that could potentially shock markets, leading to a less-controlled rise in longer-term yields.

Bond Bloat
The Fed's balance sheet has ballooned since the crisis as it bought bonds to suppress yields
Source: Federal Reserve

This plan leaves Fed members with more room to raise near-term rates, as they almost certainly will do at their June meeting. And it shows just how much policy makers would prefer to influence markets through short-term rates than by adjusting their overall debt holdings, which were built up over years of quantitative easing.

This implies that the difference between shorter and longer-term yields will more likely narrow in the near term, barring some unexpected increase in inflation. This is what happened Wednesday. 

Narrowing Curve
The gap between long and short-term rates has narrowed as the Fed plans to shrink its books
Source: Bloomberg

It sounds scary to think that the Fed will soon reduce its war chest of bonds. But this isn't a fire sale by any means. It's more of a tweaking around the edges. Unless there's a material change in the U.S. economic outlook or the Fed's plan, its balance-sheet reductions won't be particularly disruptive.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net