Signs that the Federal Reserve is weighing whether to slow down — and potentially bring to an early end — the process of shrinking its balance is stirring a fierce debate over just how much the effort matters to financial markets and the economy.
“The Fed is going to have to deal with the balance sheet’s shrinkage. It’s not like watching paint dry as Yellen said,” said Thanos Bardas, head of global rates at Neuberger Berman, who estimated every $200 billion that rolled off the balance sheet had an equivalent impact to a quarter percentage point rate increase.
Read: Fed to stress patience and that means no interest-rate move until at least June
But skeptics say the central bank’s balance-sheet reduction hasn’t lifted long-term yields as much as feared, minimizing the effect on financial conditions. Moreover, they say shrinking the portfolio in a gradual fashion is one of the more benign ways to tighten policy, compared with raising interest rates
To Bardas and other critics, however, the central bank’s balance-sheet reductions have already pinched financial conditions, dragging on economic growth and hindering prospects for the stock market’s return to its October highs. Such concerns extend the controversy over the central bank’s use of the balance sheet, which ballooned in the aftermath of the 2007-09 financial crisis, a process known as quantitative easing.
The Fed has long insisted the gradual and well-telegraphed pace of the balance sheet runoff, a process termed quantitative tightening, was designed to avoid causing turmoil. But the Fed appeared to acknowledge qualms after senior Fed officials including Chairman Jerome Powell recently talked up the possibility of tweaking the process if it presented a problem.
Since October, the Fed’s $4 trillion portfolio has shrunk at a monthly rate of $50 billion as the central bank declines to reinvest the proceeds from maturing Treasurys and government-sponsored mortgage bonds.
Quantitative tightening
Plenty of market participants say the central bank’s “autopilot” stance is more problematic than the Fed portrays, though the impact on financial conditions is unclear. They argued that it was one ingredient in the torrid stock-market selloff late last year, noting that a jump in volatility arrived shortly after the pace of the balance sheet runoff reached its peak. In keeping with the Fed’s long-term plan, the pace of the roll-off accelerated in increments from $10 billion a month in October 2017 to its peak of $50 billion a month last October.
The S&P 500 SPX, +0.84% booked a loss of 9.6% last month, marking its worst December performance since 1931. Since then, the broad-based equity benchmark has rebounded strongly in January, leaving it up more than 5% for the month.
Economists say that as the central bank’s balance sheet shrinks, bank’s excess reserves also fall, putting upward pressure on short-term money market rates. The fall in reserves, in turn, have spurred competition for dollar deposits, forcing banks to pay higher rates for overnight loans. That, in turn, has translated into higher yields on short-term maturities.
“The reduction in excess reserves has forced foreign banks, which held the bulk of these excess reserves, to find alternative sources for funding. All these factors have combined to amplify the effect of quantitative tightening and push up money market rates,” wrote Steve Ricchiuto, chief economist at Mizuho Securities.
As a result, the fed funds rates, or the overnight rate at which the Fed lends cash, has threatened to overshoot its targeted range currently between 2.25% and 2.5%, drawing questions over whether the balance-sheet reduction will need to be terminated earlier than planned. Such speculation gained ground after minutes from the Fed’s December meeting said it was discussing potential changes to how it trims its crisis-era portfolio.
Read: Why the Fed may not announce a change to its balance sheet plan on Wednesday
With the Congressional Budget Office forecasting deficits north of $1 trillion from 2022, the U.S. Treasury’s strategy of relying on the sales of shorter-dated bonds to fund the government has also exacerbated the rise in short-term yields.
“Simply said, when they announced the adjustments on the balance sheet, they did not anticipate the government would run these deficits towards the end of the business cycle. That’s having a crowding out effect on credit markets,” said Bardas.
“We’ve seen more borrowing at the front-end of the curve. The increased issuance has impacted the tightening,” Yvette Klevan, a bond fund manager at Lazard Asset Management, told MarketWatch.
But others are more skeptical in part because though overnight rates and short-term rates are a crucial piece in the plumbing of financial markets, they aren’t seen as important to the broader economy.
“The impact of this shift is marginal and fairly localized in U.S. money markets,” wrote analysts at UBS.
Higher term premiums
That’s because the primary channel for tighter monetary conditions would ostensibly originate from higher long-term Treasury yields or a wider term premium, the extra yield investors demand for holding long-dated bonds over their shorter-term counterparts.
After all, analysts blamed the Fed’s bond-buying for inflating prices for risky assets by pulling the risk-free yields of Treasurys so low that investors sought richer returns in riskier assets like stocks and corporate bonds. It stood to reason, then, the shrinking balance sheet would hurt equities by pushing long-term yields for government paper higher.
The 10-year Treasury yield TMUBMUSD10Y, +0.72% however, has struggled to return to its November high of 3.25%, and has since slid to trade around 2.70%, according to Tradeweb data.
“There is little conviction at the Fed that balance sheet reduction is feeding into higher term premia for [Treasurys],” wrote Ed Al-Hussainy, senior currency and rates analyst for Columbia Threadneedle Investments.
Read: 3 reasons the stock-market selloff can’t be blamed on the Fed’s quantitative tightening
Richer long-term rates
Marvin Loh, global macro strategist at State Street, said higher yields on longer-dated maturities are widely seen as the primary channel for tighter financial conditions because they serve as the benchmark for mortgage rates, auto loans and other consumer lending products.
He said that’s why during “Operation Twist” the central bank sold short-term bills to buy longer-term bonds beginning in September 2011 in a bid to depress longer-term yields, flattening the yield curve, as measured by the spread between short-term and long-term yields.
“In terms of how financial conditions affect the real economy, the belly or, the 10-year yield, is the most important part of the curve,” said Loh.
However, he conceded the rise in short-term rates could tighten financial conditions if they surged beyond long-term yields, triggering a yield curve inversion, usually seen as a prelude to a recession. In November’s senior loan officer survey, banks said they would raise credit standards or cut back on lending if the spread between the 3-month Treasury bill TMUBMUSD03M, +0.20% and the 10-year note yield inverted. At the moment, the gap between the two maturities stands at 33 basis points.
Also check out: How a yield-curve inversion can turn into a ‘self-fulfilling’ recession prophecy
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