Expectations are currently that the Federal Reserve will announce plans to begin unwinding its balance sheet this Wednesday. When you consider that the Fed currently owns around 29% of the market for mortgage-backed securities and 17% of the market for Treasuries, you might be tempted to scream OMG!
But before you do, recognize that plans have been in place for this for quite some time, and the market has already had plenty of time to react. Not only that, but the Fed will continue to take the same “steady as she goes” attitude that has been a hallmark of Janet Yellen’s time as Fed chair.
Back in June, the Fed outlined how this process would likely unfold. They will begin by allowing $10 billion of assets ($4 billion of mortgages and $6 billion of Treasuries) to roll off the balance sheet each month. As time goes by, assuming the economy and financial markets don’t throw too big a fit, the roll-off amounts will continue to rise, up to a maximum of $50 billion per month.
One thing that’s important to understand is that during this process, the Fed will not actually sell any bonds. Instead, they will simply allow bonds to mature, and not reinvest the proceeds. This means that the incremental effect to the mortgage and Treasury markets should be mild, and not represent the “severe tightening” that some analysts are making it out to be.
Another important consideration is that the ultimate size of the Fed’s balance sheet will be much larger than prior to the financial crisis. This is because the amount of cash in circulation has grown considerably over that time. Cash in circulation is a liability on the Fed’s balance sheet, and as a result, they must maintain assets to offset that liability.
Last month, New York Fed President William Dudley estimated that the final balance sheet size would likely end up being between $2.4 trillion and $3.5 trillion. This means that even though the Fed accumulated $3.7 trillion in assets between 2008 and 2014, they will only end up eliminating approximately $1-2 trillion from their balance sheet during QT.
Also keep in mind that while the Fed is tightening, other central banks around the world are still in easing mode. As you can see in the chart below, while Federal Reserve assets have remained steady in recent years, the European Central Bank and the Bank of Japan have continued their purchases.
This means that regardless of what the Fed does, global financial conditions will remain very palatable for now, at least until the rest of the world begins to tighten as well.
Wrapping things up, I want to outline one more dynamic that may have a big impact on what quantitative tightening ultimately does to rates.
As you know by now, the long-end of the yield curve is controlled by inflation expectations. When inflation expectations rise, yields move higher and vice versa. Now, think for a moment about what quantitative tightening will do to inflation expectations …
When the Fed allows assets to mature, they are effectively increasing the supply of bonds in the market. All else being equal, this would lead to lower bond prices and higher interest rates.
But quantitative tightening is designed to (get this) tighten financial conditions. And what happens when financial conditions tighten? The economy slows and inflation expectations decline …
So in a roundabout way, QT, which many believe will lead to higher rates, could actually lead to lower inflation expectations, which would cause long-term rates to fall.
Right now, without being able to gauge any effects from the actual process, all of this is speculation. But I am pointing all of this out to make sure that you don’t take a narrow, simplistic view of how this process will unfold. Just like those who claimed QE would lead to hyperinflation, the simple narrative is almost always wrong.
If I had to venture a guess as to what QT will do to rates, I would say that these two effects (larger supply of bonds due to QT, and reduced inflation expectations due to QT) will likely cancel each other out, leaving us with a rate environment that looks quite similar to what we have today. Maybe that’s the optimist in me rationalizing things, but either way, that’s my best guess as we move into the latest phase of this foray into unconventional monetary policy.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
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