Why are markets right to worry about the Fed's ‘autopilot' runoff in the balance sheet? Because of what it signals with respect to policy interest rates…
It is evident that investors worry about the shrinking of the Federal Reserve's (Fed) balance sheet - so-called quantitative tightening (QT) - as the legacy of USD3.5 trillion of asset purchases undertaken under quantitative easing (QE) are gradually runoff.
Justified or unjustified market sell-off?
Over the coming meetings, the Federal Open Market Committee (FOMC) is expected to provide revised guidance and clarification on the runoff in its balance sheet. The credibility of ‘data dependent' monetary policy is undermined by balance sheet ‘normalisation' on ‘autopilot'.
As such, it is more than a technical change that markets have placed too much weight upon. Rather, it gives investors greater confidence that, just perhaps, the current Fed tightening cycle will end with a soft landing for the economy rather than in recession.
The catalyst for the sell-off in growth-sensitive risk assets at the end of 2018 was a dramatic re-pricing of global recession risk.
Investor worries were exacerbated by a Fed that appeared to be oblivious to the slowdown in global growth and on a pre-set path of monetary tightening.
Fed Chair Powell commented that policy rates were a ‘long way' from neutral and that the runoff in the Fed's balance sheet runoff is on ‘autopilot'. Chair Powell has since pivoted to ‘patient' on interest rates and flexibility on the ‘balance sheet normalisation'.
Contrary to the claims of many commentators, investors are right to focus on the reduction in the Fed's balance sheet and the implications for financial markets.
The runoff in the Fed's balance sheet is a form of monetary tightening as investors reduce their holdings of risky assets to absorb a bigger available pool of safe assets, a reverse of the ‘portfolio rebalancing' effect that boosted risk assets and eased financial conditions during the QE-era.
Combined with a surge in the supply of shorter maturity Treasury securities to fund tax cuts and rising federal spending in the first half of the year, the interest rates faced by the broader economy rose more than implied by hikes in the Fed policy rate.
Effective Federal funds rates & 3-month Libor rate
Source: Federal Reserve, Federal Reserve Bank of New York, ICE, Macrobond; latest data at 14 February 2019
However, in my opinion, the most important reason why markets are right to worry about the Fed's ‘autopilot' runoff in the balance sheet is what it signals with respect to policy interest rates.
Previous Fed analysis suggested that the ‘normalised' size of the balance sheet would be around USD3 trillion, implying that the runoff in the Fed's holdings of Treasury and mortgage-backed securities (MBS), currently capped at USD50 billion per month, would not end until sometime in 2021.
Although in theory the FOMC could suspend or end QT at short notice, the ‘autopilot' guidance implied that the bar for doing so is high.
A Fed on a pre-determined path for its balance sheet effectively precludes the potential for interest rate cuts as it is difficult to envisage a scenario whereby the Fed would be cutting interest rates while simultaneously squeezing liquidity in money markets.
With global growth slowing and rising policy uncertainty, especially regarding international trade, along with an apparently inflexible Fed, the market discounted a much ‘fatter' tail risk of recession.
Balance sheet normalisation
The FOMC bowed to market concerns by abandoning ‘autopilot' runoff of its balance sheet, in place since October 2017. At its 30 January meeting, the FOMC announced it will revise its guidance on its ‘balance sheet normalisation' and is prepared to alter the size and composition of its balance sheet in support of more accommodative monetary policy if warranted by future economic conditions.
More recently, FOMC members, notably the typically ‘hawkish' Cleveland Fed President Loretta Mester, confirmed that "at coming meetings, we will be finalising our plans for ending the balance sheet runoff and completing balance sheet normalisation".
The FOMC is likely to conclude that it will have to maintain a bigger than previously anticipated balance sheet; bigger than previously anticipated in order to satisfy banks' demand for reserves (deposits with the Fed), in large part due to regulations that favour safe liquid assets such as the liquidity coverage ratio.
Despite current bank reserves of USD1.6 trillion, the FOMC has twice raised the IOER - the interest rate it pays on bank reserves - by less than the increase in the Fed funds rate because the effective rate for borrowing from the Fed is gravitating towards the upper bound of its target range.
A recent Fed survey of banks implied an aggregate demand for reserves of USD850 billion and in order to ensure reserves are ‘ample', the ‘equilibrium' level of bank reserves could be USD1 trillion or even greater.
Other key liability drivers of the Fed's balance sheet include the demand for currency - rising by almost 7% annually over the last 30 years - and much less predictably, the Treasury's cash account currently around USD400 billion.
Accommodating USD1 trillion of bank reserves on its balance sheet as well as growth in currency and the Treasury account implies a total balance sheet size of USD3.4 trillion compared to USD4 trillion currently.
At the current pace of runoff in Fed holdings of Treasury bonds and MBS, QT would come to an end at least one year earlier than previously anticipated in April or May of 2021.
Federal Reserve balance sheet - approaching the end-point
Source: Macrobond, Federal Reserve, BlueBay Asset Management projections from January 2019
A new normal
Over its next few meetings, the FOMC will clarify the end point for the current runoff in the balance sheet from not reinvesting its holdings of maturing Treasury and MBS.
The normalisation of the Fed's balance sheet has proved more interesting to investors than ‘watching paint dry', as hoped by former Fed Chair Janet Yellen, who put the current policy in place.
The shrinking Fed balance sheet as well as interest rate hikes has delivered the tightening in monetary and financial conditions warranted by a US economy enjoying above trend growth and near full employment.
But for the FOMC to credibly claim that monetary policy is now ‘data dependent' rather than on a predetermined ‘normalisation' path, it must clarify and end its QT sooner rather than later.
Failure to do so will result in further episodes of market volatility as investors attach a greater probability to the risk that, like previous tightening cycles, it will end with recession rather than a soft landing to a sustainable growth rate
David Riley, Chief Investment Strategist at BlueBay Asset Management