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# 03 March 2017 Achevé de rédiger le 27 février2017 2 How will the Fed’s balance sheet return The essential to normal? BASTIEN DRUT, Strategy and Economic Research Since the fed funds hike in December 2016 (the second of this cycle) and with encouraging signs on inflation, the balance sheet normalisation has become a hot topic, for FOMC members and market players. This is a source of worry for some, given the dollar amounts involved. In response to the Great Recession of 2008/2009 and the weak growth that ensued, the Fed launched several operations to purchase massive amounts of assets financed by money creation. These transactions are also known as «Quantitative Easing» (QE). The size of the Fed’s balance sheet rose from under $900 bn in late 2007 to about $4.5 trillion today. In its assets column, the Fed owns $2.46 trillion in U.S. Treasury securities and $1.75 trillion in MortgageBacked Securities (MBS). Although the last QE3 purchases took place in late 2014, the Fed has kept the size of these US Treasury and MBS holdings unchanged, reinvesting the securities as they reach maturity. Treasury securities the Fed holds started to mature in earnest in 2016. $200 bn will reach maturity in 2017, and nearly $430 bn in 2018. The amounts involved are therefore very large, because net issues of long-term U.S. Treasuries in 2016 was $392 bn. Overall the market expects that the end of reinvestment of maturing Fed-held securities will take place gradually and in a limited fashion. In the years that preceded the crisis, the Fed held almost as much in Treasury securities on the asset side of its balance sheet as currency in circulation on the liability side, and held no mortgagebacked securities. In the event that the Fed returns to its pre-Great Recession balance sheet, its goal should be to stop reinvesting maturing MBS so that it ultimately holds none at all. Furthermore, the continuing growth of currency in circulation makes the need for a reduction in Treasury holdings relatively modest and non-urgent. In September 2014, the Fed published its «Policy Normalisation Principles and Plans». The key points were as follows: ••First, raise the fed funds rates. ••Next, reduce securities holdings in a gradual and predictable fashion by ceasing to reinvest the repaid principal of maturing securities. ••Ultimately, the Fed “will hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities, thereby minimising the effect of Fed holdings on the allocation of credit across sectors of the economy”. Only after the first rise in the fed funds rate, in December 2015, did the FOMC’s communication about the balance sheet change, to indicate that the Fed intended to continue its reinvestment policy «until normalisation of the level of the federal funds rate is well under way», which is subject to interpretation. Since the second fed funds increase, in December 2016, and encouraging signs regarding inflation, the topic of the balance sheet’s normalisation has started to be discussed more and more. Several FOMC members have made statements on this matter since the start of 2017: ••Patrick Harker, President of the Philadelphia Fed and voting in 2017, declared in early January that the Fed might end the reinvestment of maturing securities once the fed funds rate has reached 1%. English version Graph n° 23 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 The Survey of Primary Dealers Autres conducted by the New York Fed among the leading dealers of Treasuries provides very signs about market expectations Liquidité CT auxinteresting institutions financières when it comes to the Fed’s balance normalisation policy. During the survey Liquidité CT auxsheet emprunteurs/investisseurs MBS conducted before the 20 January FOMC, the market expects on average that Titres du Trésor the Fed will alter its balance sheet policy when the fed funds rate reaches Source : Datastream, Recherche Amundi 1.50% (compared to 0.75% today), which the market believes will happen at the 2006 500 What are the market’s expectations with respect to balance sheet 0 policy? 2004 2500 ••Janet Yellen, Chair of the Board of Governors, explained in testimony to 2000 Congress that the balance sheet would be reduced gradually, when the Fed 1500 «is confident 1000 that the economy is on the right path.» 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 0 Fed: assets(in (in$bn) $bn) Fed: assets 2003 5000 ••Lael Brainard, a member of the Board of Governors, said on 17 January 4500 that the Fed4000 would need to consider to cease reinvestments sooner than expected if fiscal 3500 stimulus measures were to cause slack in the economy to erode faster. 3000 1 2005 French version ••Eric Rosengren, President of the Boston Fed, indicated that the Fed should consider reduce the size of its balance sheet, saying in particular: «There are Fed : actifs (en Mds$) n°1 some benefits to actually tightening not just on short rates but also possibly on long rates.» Others ST liquidity to sound financial institutions ST liquidity directly to borrowers and investors MBS & GSE debt US Treasuries Source: Datastream, Amundi Research Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry 2500 The fact that these 2500excess reserves are paid by the Fed at a rate that matches the upper bound of the fed funds target (currently 0.75%) while the fed funds 2000 target range is2000 expected to be raised gradually in the coming quarters constitutes an issue as: 1) the Fed’s interest expenses will rise rapidly and 1500 1500 they might weigh on the Fed’s profits and 2) some politicians will criticize a situation where1000 the Fed would “subside” the banks while the latter would not 1000 lend enough the real economy according to them. 201 201 201 201 201 201 2015 2015 2016 2016 2017 2017 2000 2000 1500 1500 1000 1000 2019 2019 2021 2021 2015 2015 2017 2017 2011 2011 2013 2013 2007 2007 2009 2009 2003 2003 2005 2005 2001 2001 1999 1999 1997 1997 00 USTreasuries Treasuriesheld heldby bythe theFed Fed US Currency in in circulation circulation Currency Currencyinincirculation circulation(simulation) (simulation) Currency Source:Datastream, Datastream,Amundi AmundiResearch Research Source: Survey of Primary Primary Dealers: wherewill willbe bethe the SOMA Survey of Dealers: where Survey of Primary Dealers: where willSOMA the Primary Dealers: where will be the SOMA 4Survey ofSOMA portfolio be at end-2019? portfolio atend-2019? end-2019? portfolio at 45% 45% 40% 40% 35% 35% 30% 30% 25% 25% 20% 20% 15% 15% 10% 10% Source:NY NYFed, Fed,Amundi AmundiResearch Research Source: Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry >4501 >4501 bn bn 4001 4001 -- 4500 4500 bn bn 0% 0% 3501 3501 -- 4000 4000 bn bn 5% 5% 3001 3001 -- 3500 3500 bn bn >4501 >4501 Mds Mds 4001 4001 -- 4500 4500 Mds Mds 3501 -- 4000 4000 Mds Mds 3501 Probabilité If the Fed returns to its pre-crisis balance sheet configuration, its goal would 45% 45% security holdings in line with the amount of currency be to bring its Treasury 40% in circulation, but if40% the supply of currency in circulation were to continue to 35% grow at the average pace of the last five years (+7.3% per year), it would be 35% expected to reach30% slightly more than $2.1 trillion by the end of 2021, which 30% is ultimately not so far from the current $2.46 trillion in Treasury holdings. 25% 25% Under these conditions, is there an urgent need to decrease holdings 20% 20% of Treasuries? The answer is “no”, and if the decision not to reinvest 15% 15% maturing Treasuries was made, it would only be temporary and the 10% 10% amplitude relatively limited. 5% 3001 -- 3500 3500 Mds Mds 3001 2500 2500 << 3000 3000 bn bn titres de la la Fed Fed fin fin 2019? titres de 2021 2021 2019 2019 2017 2017 2015 2015 2013 2013 2011 2011 2009 2009 2007 2007 2005 2005 2003 2003 2001 2001 1999 1999 00 The «Policy Normalisation Principles and Plans» indicates that ultimately, the Fed will no longer be holding securities beyond what is needed to implement its monetary policy efficiently and effectively, and that it will hold primarily du parat du Trésor Trésor détenus détenus Treasury securities. It mayTitres be instructive to look the Fed balance sheet’s Titres la Fed Monnaie Monnaie en en circulation circulation structure before the Great Recession of 2008/2009. In the years that preceded Monnaie en (simulation) en circulation circulation the crisis, the Fed held almost as much in Treasury securities on the asset side Monnaie of its balance sheet as currency in circulation on the liabilities side, and held Source Amundi Source :: Datastream, Datastream, Recherche Recherche Amundi no Mortgage-Backed Securities. Returning to this configuration would indicate that the Fed’s goal should be to stop reinvesting maturing MortgageBacked Securities so that it ultimately holds none at all. This will remove Enquête Primary où Dealers: où sera sera le portefeuille de Enquête Primary Dealers: some support from the mortgage loan market. n°4 n°4 3000 Mds Mds << 3000 Currency in circulation vs US Tresuries Currency in incirculation circulationvs vsUS USTresuries Tresuriesheld heldby bythe the 3Currency held by the Fed (inFed $bn)(in $bn) Fed (in $bn) 500 500 What is the end goal for the balance sheet? 1997 1997 Source:Datastream, Datastream,Amundi AmundiResearch Research Source: Probability 500 500 2012 2012 2013 2013 2014 2014 Others Others Reservebalances balances Reserve Deposits other other than thanreserves reservesbalances balances Deposits Reverserepurchase repurchaseagreements agreements Reverse Currency in in circulation circulation Currency Autres Autres Since December 2008, theRéserves Fed has des banques desstarted banquesto use the interest rate on bank Réserves Dépôts autres que autres Since que réserves réserves reserves as a tool of monetary policy. then, the Fed communicates on a Dépôts Reverse agreements Reverse repurchase agreements fed funds target range (and not onrepurchase an unique target rate) in which it wants the circulation en circulation Monnaie effective fed funds rate toMonnaie be anden whose upper end corresponds to the rate ::Datastream, Recherche Source Datastream, Recherche Amundi Amundi at which excessSource reserves are remunerated: the IOER rate, the Interest rate On Excess Reserves. The reasoning is the following: banks will be unwilling to hold other assets that do not pay at least the rate of interest on excess reserves: this should raiseMonnaie short-term market interest However, en vs du vs titres titresrates. du Trésor Monnaie en circulation circulation détenusas paronly banks hold n°3 n°3 reserves, market rates are generally below the$)IOER rate. la (en la Fed Fed (en Mds Mds 2009 2009 2010 2010 2011 2011 5000 5000 4500 4500 4000 4000 3500 3500 3000 3000 2500 2500 2000 2000 1500 1500 1000 1000 500 500 00 2017 2017 2014 2014 2015 2015 2016 2016 2013 2013 2011 2011 2012 2012 2009 2009 2010 2010 2007 2007 2008 2008 Fed: liabilities (in $bn) Fed:liabilities liabilities (in $bn) Fed: (in $bn) 2006 2006 2007 2007 2008 2008 1500 1500 The Fed’s substantial expansion during its phases of QE coincided with a steep 1000 1000 rise in the bank’s 500 excess reserves (see the box below on “the mechanics of QE”). 500 The thing is the existence of these very high excess reserves complicates the 00 management of the fed funds rate by the Fed (the fed funds rate is the overnight rate at which banks lend reserves to each other). 2 2003 2003 2004 2004 2005 2005 2500 2500 Source: Amundi Source: NY NY Fed, Fed, Recherche Recherche Amundi 201 201 201 201 201 201 Source:Datastream, Datastream,Amundi AmundiResearch Research Source: What problems may arise from having too large a balance sheet? 2000 2000 5% 0% 0% 200 200 201 201 201 201 # 03 end of H1 2018. We should note that two primary dealers of the 21 surveyed do Fed Mds$) passif (en (enpolicy Mds$)to end. For the most part, n°2the Fed :: passif n°2 not expect the US Treasuries reinvestment primary dealers believe that reinvestments will cease only gradually: no sudden 5000 5000 end to the reinvestments. They believe that the average probability that the 4500still be more than $3.5 trillion at the end of 2019 is 71%, balance sheet 4500 will 4000 4000 which indicates that the expected balance sheet reduction is relatively 3500 3500 modest. 3000 3000 2005 2005 2006 2006 200 200 200 200 200 200 Others Others ST liquidity liquidityto tosound soundfinancial financialinstitutions institutions ST ST liquidity liquiditydirectly directlyto toborrowers borrowersand andinvestors investors ST MBS &&GSE GSEdebt debt MBS US Treasuries Treasuries US Source Amundi Source :: Datastream, Datastream, Recherche Recherche Amundi 2003 2003 2004 2004 200 200 200 200 200 200 201 201 201 201 201 201 201 201 201 201 201 201 201 201 200 200 201 201 200 200 200 200 200 200 200 200 200 200 200 200 March 2017 Autres Autres Liquidité aux institutions institutions financières Liquidité CT CT aux Liquidité aux emprunteurs/investisseurs emprunteurs/investisseurs Liquidité CT CT aux MBS MBS Titres Titres du du Trésor Trésor 24 # 03 March 2017 > T he quantitative easing mechanism The Fed’s QE has consisted in purchases of securities (Treasuries, MBS, agency bonds) financed by central bank money created for this purpose. These securities have shown up on the asset side of the Fed’s balance sheet, while the increase in bank reserves has shown up in the Fed’s liabilities for an equivalent amount. QE has thus mechanically expanded the Fed’s balance sheet. Did banks sell Treasuries to the Fed? If the banks had sold their own Treasuries to the Fed, their balance sheet would not have expanded, and QE’s only impact would have been a shift in the breakdown of their assets (from Treasuries to the reserves held with the Fed). However, a look at the breakdown of holdings of US Treasuries shows that US banks have been net buyers of them during QE phases. In reality, the banks, who are the only ones holding accounts with the Fed, have actually served as an intermediary. Let’s take the example of an investor who sells securities to the Fed through a bank. In this case, the investors’ transaction is first recognised in the bank’s liabilities, and the bank’s sale of securities to the Fed leads to an increase in the bank’s excess reserves in its assets and an equivalent increase in deposits in its liabilities. So QE operations have not caused just the Fed’s balance sheet to expand but also US banks’ balance sheets. What about the reinvestment of maturing Treasuries? The Fed reinvests the amounts from maturing securities directly on the primary market with the US Treasury, without the use of intermediaries. The reinvestments are split among the Treasury auctions held the day of maturities (prorated to the volume of each of the auctions held that day). When the Fed ultimately decides to no longer reinvest the securities it holds, other investors will take over and their bank deposits will decline, which will lead to a decline in banks’ excess reserves. 25 Document for the exclusive attention of professional clients, investment services providers and any other professional of the financial industry #03 March 2017 Recent publications Amundi Research Center Top-down Asset Allocation Bottom-up Corporate Bonds Fixed Income Working Papers Portfolio optimisation in an uncertain world Marielle de jong — Quantitative Research T he Reactive Covariance Model and its implications in asset allocation Eduardo Abi Jaber — Quantitative Analyst – ENSAE ParisTech — Dave Benichou, Portfolio Manager, Hassan Malongo — Quantitative Research O n the stationarity of dynamic conditional correlation models Jean-David Fermanian — Professor of Finance & Statistics, CREST/ENSAE — Hassan Malongo — Quantitative Research Discussion Papers Series Cycles and asset allocation: key investment decisions Éric Mijot — Strategy and Economic Research Human rights and businesses: How can one assess the corporate responsibility to protect human rights? 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