The Federal Reserve is about to start shrinking its massive balance sheet. Officials say the process will run in the background, but it probably will not. Investors should brace for an extended period of uncertainty and volatility.
When the central bank released minutes this past week from its March meeting, it suggested that, in May, it would begin unwinding some of the trillions of dollars in pandemic bond purchases it made over the past two years. That would be lightning-fast, given that quantitative easing just ended. The last time the Fed conducted quantitative tightening, or QT, it waited two years after interest-rate liftoff to shrink its balance sheet. Its newly suggested plan would amount to double policy tightening — half of which investors might be missing.
We know that policy makers would have raised rates by a half-point in March had Russia not invaded Ukraine, and the meeting minutes and recent Fedspeak suggest that many officials favor at least one 0.5% increase at future meetings. Traders are pricing in 80% odds of a half-point rise in May and a 50% chance of another in June, according to CME data.
But QT is not even close to being priced into markets, says Peter Boockvar, chief investment officer at Bleakley Advisory Group.
It makes sense that more attention is falling on rates than balance-sheet reduction. Whereas economists, market analysts, and corporate executives can easily model for interest-rate changes, QT has happened only once before. And, as Boockvar notes, it occurred at a glacial speed. Investors have new details about how the Fed intends to handle its $ 9 trillion portfolio — which has doubled since the start of the pandemic and represents roughly 40% of gross domestic product — but how that ripples through the economy and markets is the great unknown.
As Fed Chairman Jerome Powell put it earlier this year, “I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions. [The] balance sheet is still a relatively new thing for the markets and for us, so we’re less certain about that. ”
Here is what we know so far: The Fed signaled that it would let its balance sheet run down by $ 60 billion in Treasuries and $ 35 billion in mortgage-backed securities a month, ramping up to that pace over three months. It will let these maturing securities roll off, instead of reinvesting the proceeds.
That’s easy enough on the Treasury side of the portfolio, at least for the next year or so. Boockvar notes that about a fifth of the Fed’s $ 5.8 trillion in Treasury holdings mature in a year or less, and about 30% of that chunk will do so in less than three months. And Barry Knapp, director of research at Ironsides Macroeconomics, says that the roughly $ 4 trillion in bank deposits and another couple of trillion in cash parked at the central bank means it will take at least a year to soak up excess liquidity.
It’s much trickier on the mortgage-backed securities side. Part of the problem: As rates rise, prepayments fall. That lengthens the duration of the Fed’s MBS holdings, limiting the short-term natural runoff. In November 2021, the conditional prepayment rate was roughly 30%, data from S&P Global show. If prepayments slow to a 10% rate — as they did at the peak of the 2017-19 tightening cycle — MBS runoff would average about $ 20 billion per month, says Jefferies chief economist Aneta Markowska. That is well below the $ 35 billion cap the Federal Reserve has signaled, and it means it would have to sell roughly $ 15 billion in mortgage-backed securities a month to meet its target.
Not long ago, the idea that the Fed would sell MBS was shocking. Now, Wall Street thinks outright sales will not happen until 2023 at the earliest; Boockvar says it will be much sooner.
Here’s what else we know about QT. While rates more directly touch demand, quantitative operations more directly affect asset prices. QE significantly boosted those prices as the Fed bought, and investors should expect a symmetrical result with QT, though the Fed will not fully reverse its pandemic purchases. Boockvar says that each $ 1 trillion in QT equals about 0.5% in additional tightening. But how far will stocks and home prices fall? No one seems to know.
Of the other known unknowns, here are a few to ponder:
When the Fed sells MBS, there will be buyers, including banks, insurance companies, and pension funds, says Joseph Wang, a former senior trader on the Fed’s open markets desk. But he notes that over the next several years, about $ 2 trillion in QT is going to overlap with historically high Treasury issuance. That means a lot more supply for investors to absorb, even before MBS sales. And, Wang adds, recent fund flows suggest waning demand for Treasuries. “Even the most ardent bond bulls will not have enough money to absorb the flood of issuance, so prices must drop to draw new buyers,” he observes. So, how far will prices need to drop, and how high will yields need to rise?
Then there’s the impact on housing. How the Fed handles the MBS unwinding is crucial to what happens to the overall economy. The central bank must cool the housing market, which makes up 40% of consumer price inflation and a fifth of GDP. But what happens when demand slows but prices still rise because of low inventory?
And finally, when the central bank sells MBS, it’s likely to do so at a significant loss. Who will eat it?
The Fed this past week gave more QT details than many strategists had expected. But there are still more questions than answers, with investors and policy makers together in the dark.
Write to Lisa Beilfuss at firstname.lastname@example.org