For the first time, the Janet Yellen set into motion firm plans to reduce the size of its $4.5 trillion dollar "balance sheet." Such a process has been talked about for years, but many were convinced, myself included, that it would always just be talk. The balance sheet consists of Treasury and mortgage-backed bonds that the Fed amassed during the experiment with quantitative easing between 2009 and 2014. During that time, the Fed injected liquidity into the financial markets by creating money to purchase more than $80 billion per month (at times) of such securities. These efforts pushed down long term interest rates, drove up bond and real estate prices, and set the stage for a massive stock market rally that had little to do with underlying economic fundamentals. Despite several informal hints over the years that these stockpiles were being reduced through bond maturation, the war chest has not decreased in size by one iota. However, the Fed has admitted that these ponderous holdings will limit its ability to stimulate in the event of future recessions. As a result, it wants to shrink the balance sheet down to a more manageable size now, precisely so it can expand it again during the next recession.
To do this, the Fed must essentially perform quantitative easing in reverse. It must sell, or force the Treasury to sell, treasuries and mortgage-backed securities into the current market. This process will reduce the Fed's balance sheet while drawing free cash out of the economy, thereby unwinding prior stimulus. The Fed even told us how large the reductions will be...and it's a lot. Much in the way that the Fed "tapered" out of its QE program back in 2014, gradually reducing the $85 billion of monthly purchases by about $10 billion per month, the Fed anticipates a similar approach to what is, in effect, a "quantitative tightening" campaign, or QT for short. It will start by allowing it's balance sheet to shrink by $10 billion per month (total) of mortgage and government bonds, and will gradually increase the reductions to $50 billion per month, or $600 billion per year. Those are very big numbers that will provide very real headwinds to the economy and the financial markets.
But it's important to realize that the Fed envisions doing this at a time when Federal deficits are likely to be rising steeply . In the next few years, the Congressional Budget Office estimates that Federal budget gaps will be in at the $700 - $800 billion dollar range annually (hitting $1 trillion by 2021 or 2022). These assumptions of course do not factor in any potential any tax cuts, spending increases, or recessions (I think we are likely to get all three). So this means that in a few years, the Treasury will have to sell $600 billion of additional bonds into the market annually to repay the Fed while at the same time selling $800 billion or more to finance its current deficits. That may create some traffic problems. Should we assume that there are enough buyers to step up to the plate, especially if yields stay as low as they are? It's not likely.
With so much supply hitting the market at once, bond prices will have to fall (and yields rise) in order to attract buyers. This will amplify the tightening effect that these sales are meant to generate. Higher yields will also add a tremendous burden to the U.S. Treasury. With outstanding Federal debt already at $20 trillion, every percentage point rise in rates translates into approximately $200 billion more per year in debt service costs, which also must be borrowed. After the Fed announcement, Mick Mulvaney, the Director of the Office of Management and Budget admitted that quantitative tightening from the Fed had not factored into the Administration's long-term budget projections.
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Livio S. Nespoli has been a broker, registered investment advisor, and financial publisher since 1985.