When it comes to the Federal Reserve's balance sheet, markets have more questions than answers — but that could change in coming months, starting Wednesday with the release of minutes of the central bank's March meeting.
The Fed kicked off serious discussion of its plan for unwinding its $4.5 trillion balance sheet at that March 14-15 gathering, officials have said, and this will be the first proper description investors receive of the conversation that took place behind closed doors. Even before those details go live at 2 p.m. in Washington, some on the policy-setting Federal Open Market Committee have already provided an outline of the debate via their post-meeting commentary.
"They are laying the groundwork and giving the market ample time to digest the different scenarios the Fed would do," said Sean Simko, who manages $8 billion in fixed-income assets at SEI Investments Co. in Oaks, Pennsylvania.
Below is a cheat sheet detailing key balance sheet-related topics, what policy makers have already said about them, and what the minutes could flesh out.
When the FOMC does decide to begin shrinking its balance sheet, it may also take a breather from interest-rate increases, New York Fed President William Dudley said in a March 31 Bloomberg Television interview.
“If we start to normalize the balance sheet, that’s a substitute for short-term rate hikes,” and “we might actually decide at the same time to take a little pause in terms of raising short-term interest rates,” Dudley said.
His remarks caused investors to mark down the chances of a rate increase in the first half of 2018 to the lowest since mid-November, according to the prices of federal funds futures contracts. If the minutes back them up, that will be important.
Not an Active Tool
That said, it's clear that the Fed wants to let runoff play out in the background, rather than actively adjusting it to tighten policy. This is one of the areas where officials seem to have reached consensus.
"We have emphasized for quite some time that the committee wishes to use variations in the Fed funds rate target or short-term interest rate target as our key active tool of policy," Chair Janet Yellen said during her March 15 press conference. The balance sheet is "not a tool that we would want to use as a routine tool of policy." As part of that, the Fed seems to be looking toward a gradual roll-off by stopping reinvestment as securities mature.
There are two separate timing elements in question: first, when the Fed will announce its plan for rolling off the balance sheet, and second, when that process will begin. They're both unresolved, so don't expect anything conclusive in the minutes.
Dallas Fed President Robert Kaplan, a policy voter this year, has said the Fed should set out a clear plan for what it's going to do with its holdings, and that it is "approaching" a time when they can make such an announcement.
Fed officials have said the changes themselves will start once rate increases are "well underway," but have offered little clarity about what that means. Governor Jerome Powell said on March 28 that it’s too soon to predict when any reduction of the Fed's assets might begin, and San Francisco Fed President John Williams said on March 23 that while the Fed is "not quite there," they’ll "be closer towards the end of this year to be ready to start that process of the normalization of the balance sheet.” Williams doesn't vote in 2017.
Treasuries First, MBS First?
The Fed bought both Treasury and mortgage-backed securities as it took emergency steps to support the economy. Officials could choose to stop reinvesting both at the same time or could let one type of security run off first, and the decision could be consequential. Over $425 billion-worth of its Treasury holdings come due next year, while Fed reinvestment in the MBS market over the past 12 months has been about $350 billion, or more than 20 percent of the market's total issuance in 2016. They could also whittle their balance sheet down until it's Treasury-only, as it was prior to the crisis, or leave it as a mix. This is an area of active debate, which the minutes could reflect.
Kaplan prefers rolling off both types of securities, but allows that the timelines might differ. "Each is a different market, the sizes and daily market volumes are different in each," he told reporters on March 23. "Our plan should be to address both of those types of securities, and have an announced plan for how we’ll allow each of those to run off.”
Cleveland Fed President Loretta Mester, who doesn't vote on policy this year, has said she'd favor "returning its composition to primarily Treasury securities over time." Philadelphia Fed's Patrick Harker, who does vote in 2017, says that he'd prefer a Treasury-heavy portfolio, but that he's "not necessarily convinced yet that we should completely get out of MBS."
Fed officials have indicated that the balance sheet will probably be larger than it had been historically when they finish shrinking it, but no one has set a clear end point. The Fed can begin shrinking its balance sheet before knowing where it will stop, Williams said on March 29. “We could start a normalization of the balance sheet and then make a decision, do we stop at X or Y,'' he said.
One of the major issues in the size debate is whether the Fed wants to maintain a corridor or floor system for setting rates. In a corridor system, the Fed's discount rate is set above the target interest rate and the interest-on-reserves rate is set below it, and the Fed adds or drains liquidity from the market to ensure that rates stay in the middle. With a floor system, the interest-on-reserves rate is set very close or equal to the target rate.
The first system is more conventional but doesn't work when the balance sheet is really big, and there's a lot of excess liquidity in the system. The central bank has been relying on a floor approach since it starting hiking rates in December 2015.
"When we talk about what size the balance sheet ought to get to, and what the system ought to be, this is one I'm actually going to advocate around the table. We speak with one voice, we put it out in an announcement, and Fed presidents are careful," Kaplan said after a speech on March 30. Speaking with multiple voices "could create a lot of confusion, could be really problematic."
In fact, if there's one sure consensus in the discussion about the balance sheet, it's that officials don't want to spook markets by repeating their mistake of 2013. That was when then-Chairman Ben Bernanke sent yields soaring by unexpectedly disclosing the Fed might taper its bond purchases in the next few meetings.
Dudley said last week that he's not worried about the debt market reacting in a "violent way" to the Fed starting to slow reinvestments because most forecasters already predict it happening by at least some time in 2018.
Wall Street analysts don't agree. Some see a risk that yields could actually rise sharply, especially because the Fed change may come during a time when the European Central Bank is slowing its bond buying.
"People are not yet paying nearly as much attention to or pricing-in the potential impact of the Fed tapering reinvestments," said Subadra Rajappa, head of U.S. interest-rate strategy at Societe Generale SA in New York, noting that the global central bank policy environment is also poised to shift. "So I am not convinced the start of balance sheet adjustment won't cause a lot of volatility.''
The 10-year Treasury term premium, a measure of the extra compensation investors demand to hold a longer-term instrument instead of rolling over a series of shorter-dated obligations, last month reached the lowest level since the U.S. presidential election on Nov. 8, a New York Fed model shows. That premium and therefore outright yields would be higher, says Rajappa, if traders already were factoring in the Fed slowing reinvestment.
For more details on the Fed's balance sheet unwind, see Bloomberg's QuickTake.