How the Fed Could Unwind Its Balance Sheet
In her testimony before the Senate Banking Committee, Federal Reserve Chair Janet Yellen explained a strategy for unwinding the central bank’s balance sheet. Three factors could determine how this could unfold. The reduction must be gradual, it must be natural and there must be a communication plan. That means investors could encounter three effects: the stock-flow effect, the risk effect and the communication effect.
Fed research in 2012 estimated that for every $300 billion in Treasury bond purchases, yields declined by 30 basis points due to the “stock effect,” which happens because the reduction of available stock of Treasury debt to the public is likely to drive up the price and lower the yield of Treasury bonds. The “flow effect” was estimated by Fed research to be worth 3.5 basis points per Treasury auction. However, this effect depends however entirely on demand at the time of the auction.
Historically, a way to measure the flow effect is by expressing issuance of 10-year Treasury notes as a percentage of total issuance. The stock effect is quantified by the amount of outstanding 10-year Treasury notes as a percentage of total Treasury debt. Fig. 1 compares each effect as the blue line (“flow”) and green line (“stock”) to the change in the 10-year yield. A decline in yields coincided with a reduction in 10-year Treasury notes available, especially around when quantitative easing ended. A rise or fall of 10-year note issuance as percentage of total issuance changed yields only marginally.
There are concerns that when the Fed stops reinvesting maturing Treasury and mortgage holdings, markets would “reprice” the risk premium associated with those holdings. To understand the risk of a change in stock, one measure is the concept of “10-year equivalents.” This estimates the number of 10-year notes that would produce the same degree of overall interest rate risk in a portfolio.
The Fed’s portfolio currently holds about $1.5 trillion of 10-year equivalents in Treasury bonds. This is about $1 trillion more than would have been held under a traditional Fed portfolio approach. Relative to the outstanding Treasury debt expressed in 10-year equivalents, the Fed’s portfolio has already seen a reduction of 10-year risk by $350 billion since the third quarter ended in the fall of 2014. The impact on the 10-year yield however has been modest: only 6 basis points higher since the end of the third quarter.
The Fed’s holdings of mortgage-backed securities and the outstanding MBS expressed in 10-year equivalent has a more volatile nature. Fig. 3 shows that when MBS duration extends or contracts due to a change in prepayment speeds, MBS in 10-year risk terms fluctuates sharply. Although the supply of available mortgage bonds may increase when reinvestments halt, the market is uncertain about the precise impact on mortgage rates. In addition, the gap between 10-year equivalent risk of $910 billion on the Fed’s balance sheet and the overall MBS market is smaller.
In a February 2011 speech, then Vice Chair Yellen laid out a framework for managing the balance sheet. Fig. 4 shows Yellen’s original baseline scenario of shrinking the balance sheet toward the natural growth rate (black dotted line). Today, there is a gap of $2.5 trillion between the balance sheet and the natural growth rate. If the Yellen’s balance sheet framework had been effectively communicated, it would have implied a $300 to $500 billion reduction of the balance sheet per year over the next five years.
The Fed is in position to put in place a plan for dealing with the unwinding of the balance sheet. For markets, that means less uncertainty about how the unwinding will be carried out. That could limit risk associated with the reduction of balance-sheet holdings in terms of liquidity, stock-flow and communication. Only if there is a true political interference -- such as congressional oversight or pressure -- could a rapid runoff scenario (as presented by Yellen in her 2011 speech) materialize. So far markets have taken a benign view, despite critical rhetoric related to the conduct of monetary policy.
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