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Minds on the Markets
Archive: September 25, 2023
Don’t Forget the Fed’s Balance Sheet
Even though the September FOMC meeting did not produce any further rate hikes, that didn’t stop the Treasury (UST) market from selling off. Indeed, it has become increasingly apparent the UST arena has finally bought into the Fed’s higher for longer mantra. In fact, the UST 10-year yield broke through the 4.50% threshold in intra-day trading last week, the first occurrence at this level since the fall of 2007.
While the debate between now and year-end will focus on “will they or won’t they” in terms of one more rate hike (the dot plots say they will), the money and bond markets should not lose sight of another piece of the Fed’s toolkit, quantitative tightening, or QT. Interestingly, since around mid-2022, the policy makers have been embarking on the herculean task of reducing their balance sheet. For a little Fed 101, it’s officially known as the System Open Market Account (SOMA), the line-item which includes the Fed’s holdings of Treasuries as well as mortgage-backed (MBS) and federal agency securities.
Why did we use the term “herculean task” when describing this round of QT? Let’s dive a little deeper for some perspective. As a response to the disruptions and dislocations from COVID-19 back in March 2020, the Fed jump-started their quantitative easing (QE) program. Sure, the markets had already seen this movie before in response to the financial crisis and great recession in the forms of QE1, QE2 and QE3 (and don’t forget Operation Twist), but this new round of Fed Treasuries and MBS purchases took things to a whole new level.
The combination of the QE1, 2 and 3, brought the Fed’s SOMA holdings up from about $790 billion to a peak of roughly $4.25 trillion, rather sizeable in its own right. However, it is important to remember this increase in their balance sheet occurred over an almost six-year period. Now let’s compare those episodes to the COVID-related QE. These asset purchases took the SOMA holdings from just under $4.0 trillion to $8.5 trillion over a two-year period. In other words, the Fed more than doubled the size of their balance sheet in only a third of the time.
So, how is this round of QT going, you may be asking? That is perhaps the most important part of the equation. Much like Powell & Co. had hoped, their balance sheet reduction has been largely flying under the radar in terms of media coverage. Now that’s not to say there haven’t been some dislocations popping up once in a while in the Repo and Treasury markets, but the Fed learned from the last go-round how to hopefully mitigate the potential negative effects in the “plumbing” of the funding markets.
As it stands as of this writing, the Fed has reduced their balance sheet by roughly $1 trillion to about $7.5 trillion since QT began in June of last year. At the September FOMC meeting, the policy makers stated their intention to “continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in its previously announced plans.” In other words, that means reducing their holdings of Treasuries and agency debt/MBS by $60 billion and $35 billion per month, respectively, or $95 billion/month for those keeping track.
Thus far, the Fed has not offered any firm guidance on when this round of QT could begin to wind down. As a result, investors are still faced with a U.S. monetary policy that is considering the need for perhaps one more rate hike, pushing back the magnitude of expected rate cuts for 2024 and QT that is essentially on autopilot.
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