May 16, 2022

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Column: As before, Fed’s QT unlikely to be ‘like watching paint dry’: McGeever

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ORLANDO, Fla., Jan 6 (Reuters) – The last time the Federal Reserve laid the groundwork for shrinking its balance sheet, in 2017, then-Chair Janet Yellen said she expected the process would be “like watching paint dry.”

That is not quite how it panned out. The following year Wall Street had its biggest fall since the financial crisis, Treasury yields rose, financial conditions tightened, and the Fed halted its interest rate hiking cycle that December.

The market reaction to the Fed’s hawkish policy minutes on Wednesday suggests traders are unlikely to confuse their screens with a fresh emulsion-covered wall this time around either.

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Indeed, the volatility may be more front-loaded as the Fed figures out the framework and sequencing of its “quantitative tightening.” Markets could be in for a bumpy ride in the coming weeks.

Wednesday’s moves were instructive. The tech-heavy Nasdaq slumped 3.35%, its biggest fall in almost a year; Treasury yields hit their highest level since the early days of the pandemic last year; and the 10-year TIPS “real yield” is on course for its second-largest weekly rise in nine years.

QT will likely start sooner after the first interest rate hike and be faster than the Fed’s last attempt to reduce its bond holdings in 2018-19. read more

As Rabobank’s economists state simply: inflation is higher, the labor market is stronger and the balance sheet is larger.

Of course, the Fed will want to retain a significant degree of flexibility in its conduct of QT and will be acutely sensitive to market ructions, which could limit the downside to any market selloffs.

And it is worth bearing in mind that although the Fed’s balance sheet has doubled in size since the pandemic and the headline total of over $8 trillion is undoubtedly large, as a share of GDP it is small relative to its G4 peers.

It is around the same size as the Bank of England’s, almost half the size of the European Central Bank’s, and almost four times smaller than the Bank of Japan’s.

Share of GDP


The Fed will almost certainly be the first of these central banks to shrink its balance sheet, by allowing some bonds on its books to mature and not reinvesting the principal.

Indeed, given the concentration of Treasuries maturing within the next few years, the Fed could reduce its holdings pretty significantly over a relatively short time frame without selling a single bond.

Economists at JP Morgan estimate that balance sheet “normalization” will start this year, probably after a second projected rate hike in September.

They expect an initial runoff of $25 billion a month, comprising $15 billion of Treasuries and $10 billion MBS, rising to $100 billion a month by spring 2023. By the end of next year, the Fed’s holdings will fall by $563 billion.

Crucially, this means the private sector will have to plug the gap, they estimate. Five hundred and sixty-three billion dollars is a lot of supply coming on to the market, even though demand from pension and insurance funds, banks and overseas investors should remain high.

When the Fed started shrinking its balance sheet in early 2018, more than two years had passed since it started raising rates. The long wait reflected the Fed’s caution that the economic recovery was built on shaky foundations.

Total Assets & % of GDP


The Fed’s holdings of almost $2.5 trillion of Treasuries and around $4.4 trillion assets in total, including mortgage-backed securities, shrank to just over $2 trillion and $3.76 trillion, respectively, by mid-2019.

Then, it was reducing its asset holdings at an annual rate of around 10%. Were it to repeat that pace this time, economists at Morgan Stanley calculate that would imply a reinvestment cap of $70 billion per month ($45 billion-$50 billion on Treasuries and $20 billion-$25 billion in MBS).

Anything slower than a 10% pace and it could take several years for the balance sheet to be brought down to what could be considered a “terminal” level. This would raise the probability that “the balance sheet normalization process is never fully completed before the next recession.”

The signaling from the Fed is clear: balance sheet reduction is coming. The debate on its framework and how the Fed manages the process will intensify in the coming months via policymakers’ speeches, press conferences, minutes and policy statements.

Yellen’s successor, Jerome Powell, can reasonably argue that he has done his bit to help pull the economy through the pandemic. If turning QE into QT does end up being as uneventful as watching paint dry, that will be no small feat either.

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By Jamie McGeever in Orlando, Fla.
Editing by Matthew Lewis

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