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Investment Stewardship Guidance
Chart of the Week
May 25, 2017
Fed Balance Sheet Normalization
BEN MOHR, CFA, SENIOR RESEARCH ANALYST, FIXED INCOME
5
Fed Balance Sheet ($Trillion)
4
$1.5T
3
2
1
0
2008
2010
2012
2014
2016
2018
2020
2022
Source: Federal Reserve, SIFMA
The Federal Reserve recently increased its commentary on how and when to reduce its $4.5 trillion balance sheet,
comprised of $2.5 trillion in Treasury bonds and $2 trillion in mortgage-backed securities (MBS). Shown in this
week’s chart, that amount grew at a rapid rate from under $1 trillion during the 2008 financial crisis to where it is
today. This growth was the result of unprecedented monetary stimulus in the form of large-scale bond-buying to
keep the economy afloat by flooding it with cash through the Great Recession.
Recent commentary suggests that the Fed might gradually normalize its balance sheet later this year at an
expected rate of $1.5 trillion spread over five years. The minutes released this Wednesday from the latest
Federal Open Market Committee meeting show even more clarity on this process: The Fed intends to preannounce, on a regular basis, caps on the amounts of bonds that it would allow to mature without reinvesting.
It would start at very low caps and would then raise these caps on a quarterly basis, depending on how strongly
the economy continues to grow. The minutes stated, “Nearly all policymakers expressed a favorable view of this
general approach.”
Gradually reducing the Fed’s balance sheet may have a similar effect as hiking rates, which the Fed is expected
to continue to do. It may ultimately increase Treasury and MBS yields and put downward pressure on their prices
as the Fed reduces its role as a buyer. The market is expected to counter this effect, however, as international
demand for Treasury bonds remain strong given the continued low and negative rates in countries such as
Germany and Japan. Moreover, the market was able to absorb about $5 trillion of MBS during the housing
boom, and is expected to absorb much of the MBS that is not retained in by the Fed. The ultimate effect on
interest rates from these two opposing forces is unknown, but at the least they should mostly offset to prevent a
rapid increase in interest rates.
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