Fed Balance Sheet Unwinds

by Brad Houle, CFA, Executive Vice President

For the week, the equity markets were down more than 1 percent as investors followed political events in Washington, D.C.  While the markets have been mostly focused on the global surge in earnings growth this year, political drama took center stage this week as there are concerns that the current administration will be unable to successfully enact tax reform and deregulation. Interest rates were lower with the 10-year U.S. Treasury declining in yield from 2.21 percent to 2.18 percent.

Fed Balance Sheet Unwinds

This August marks the 10-year anniversary of the beginning of the Great Recession. This crisis began when a French bank, BNP Paribas, announced the cessation of trading with three hedge funds having trouble with subprime mortgage bond positions. The crisis then blossomed into the worst financial calamity since the Great Depression. However, one of the artifacts of the financial crisis is the $4.5 trillion in bonds that are on the Federal Reserve’s balance sheet.

In its efforts to enact quantitative easing and bolster the economy, the Fed bought U.S. Treasury-issued bonds in order to lower interest rates. These lower interest rates did help to stabilize the economy and, as a result, we are now in the eighth year of an economic expansion and the unemployment rate is down to 4.4 percent. Now the Fed has increased short-term rates to keep the economy from overheating and it is finally time to unwind the balance sheet.

 Source: Bloomberg

Source: Bloomberg

Prior to the Fed’s quantitative easing, the balance sheet was approximately $900 billion. Currently, the $4.5 trillion balance is composed of $2.5 trillion in Treasury bonds and $1.8 trillion in mortgage-backed bonds. In 2014, the Fed stopped buying new bonds except to replace what has reached maturity. Currently, in anticipation of early next year, uncertainty is growing as the Fed plans to stop reinvesting in mature bonds. As a large buyer exits the marketplace, the rest of the market is left to wonder if prices will fall and yields will rise. While we do believe that interest rates will drift higher, we do not think that we are in an environment that interest rates will spike. The world is starved for yield and U.S. Treasury bonds still yield more than most all developed nations. In addition, the dollar is still the reserve currency for the world and U.S. Treasury debt is viewed to be the safest from the standpoint of default risk. As a result, there will most likely be many willing buyers for U.S. debt even as the Fed steps away from being a large buyer.

Takeaways for the Week

  • When the Fed starts to reduce its balance sheet there is uncertainty around how interest rates will be impacted
  • With low interest rates in the developed world there will still be willing buyers as the Fed dramatically slows buying debt and lets its balance sheet wind down

Disclosures