Fed balance sheet update

| February 22, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Fed’s approach to balance sheet normalization has changed a lot over the past six months.  Amidst growing clamor by market participants to halt balance sheet run-off, Fed officials have concluded that the demand for excess reserves in the banking system is far higher than previously thought. The January FOMC minutes indicated that most Fed officials support ending balance sheet runoff later this year. Fleshing out the math behind the acceleration in the Fed’s timetable, it is quite plausible that the Fed could reach its new desired balance sheet size towards the end of 2019.

Run-off progress report: the asset side

Not surprisingly, the size of the Fed’s securities stockpile is shrinking pretty much exactly as expected.  The normalization program began in October 2017 but was phased in over a year, so that runoff only reached its maximum pace in October of last year, with caps of $30 billion per month for Treasuries and $20 billion per month for agency MBS.

There have been no surprises on the Treasury side. The Fed releases its holdings of each Treasury CUSIP on a weekly basis, so the amount maturing in any given month can be calculated exactly. Over the last three months of 2018, the Fed’s Treasury holdings fell by $74 billion, i.e. about $25 billion per month. That pace should roughly continue this year as long as the Fed maintains the current caps.

There is more uncertainty on the agency MBS side, since the pace of runoff is impacted by mortgage prepayments which typically accelerate during a refinancing boom. The $20 billion monthly caps have not yet been binding, and a refinancing wave is exceedingly unlikely any time soon.  Over the least three months of the year, the Fed’s stockpile of agency MBS declined by $45 billion, a pace of about $15 billion per month.

Halfway through the first quarter of 2019, the Q4 pace of balance sheet reduction looks to be continuing at about $120 billion per quarter.  That sounds like a lot until you realize that the Fed’s holdings are massive.  In September 2017, just before the normalization began, the Fed owned $2.5 trillion Treasuries and $1.8 trillion agency MBS.  Nearly a year and a half later, the Fed still holds $2.2 trillion Treasuries and $1.6 trillion in MBS.  If the runoff program is left to run through the end of September, the Fed will have shaved its holdings down to $2.0 trillion and $1.5 trillion respectively.  Projecting runoff through September 2020 would only get the combined total down to $3.1 trillion.

Excess reserves: the liability side

There have been few surprises on the liability side of the Fed’s balance sheet either. The two big items on that side of the ledger are currency in circulation, which grows in relation to the overall economy, and bank reserves.  Assuming some constant figure for the desired level of excess bank reserves, the target level for Fed liabilities will grow over time in line with the expansion in currency. Since the Fed began to shrink its securities holdings in October 2017, currency in circulation has grown by about $125 billion.  Currency outstanding has risen by $6 billion in each of the past four months, on a seasonally adjusted basis. A $75 billion per year pace seems reasonable, down from a prior assumption of $100 billion per year growth.

Getting to balance sheet balance

Adding up the contraction in securities holdings and the growth in currency, reserve balances have fallen by about $500 billion since the beginning of the normalization process nearly 18 months ago.  Total reserves as of about a week ago were $1.65 billion, of which close to $1½ trillion were excess reserves.

The key remaining variable in this picture is where the Fed thinks excess reserves should ultimately be.  This is where virtually all of the action has been since last year.  In 2018, comments by various Fed officials as well as simulations run by Fed staff suggested that the baseline assumption for the desired level of excess reserves was around half a trillion dollars, with the high end assumption around $1 trillion.

For much of last year, the federal funds rate tended to trade in the upper half of the target range, which several money market analysts viewed as confirmation that the comfortable level of excess reserves in the banking system was larger than initial Fed assumptions. The Fed responded to the apparent tightness in funding markets last year by twice lowering the interest on excess reserves (IOER) rate relative to the federal funds rate range by a total of 10 bp.  Then, late in the year, when the financial markets endured its first serious risk-off spasm since balance sheet normalization began, investors and analysts began blaming the Fed’s normalization policy and crying for the FOMC to stop shrinking the balance sheet.

The proposition that the Fed’s balance sheet normalization bore any responsibility for the fourth quarter market swoon was surpassingly unlikely at the time, and seems even more dubious now that markets have quickly recovered even as the Fed’s securities holdings continue to shrink.  Even so, the Fed was clearly spooked by the market action in late 2018, and in addition to shifting gears with regard to interest rates, policymakers have chosen to take a much more conservative approach to balance sheet reduction in response to the market complaints.

Fed officials and staff have pivoted recently on plans for the balance sheet.  The January FOMC minutes indicate that the bulk of the Committee believes that runoff can stop in 2019.  Indeed, a few Fed officials in recent weeks and months seem ready to taper or halt balance sheet shrinkage very soon, even with excess reserves still around $1½ trillion.

Given that the New York Fed is responsible for monitoring financial markets as well as implementing many of the Fed’s interactions with markets, it is safe to assume that New York Fed President Williams should be pretty attuned to the Fed’s thinking on this issue.  He recently stated in a Reuters interview that rolloff could end when bank reserves get to “maybe $1 trillion of reserves or somewhat more than that,” a declaration viewed as pretty close to official Fed policy.

Strictly speaking, that’s about $600 billion away, a gap which would take at least a year to close.  However, the FOMC minutes introduced a new concept that could point to a somewhat earlier halt.  The Committee considered a scenario where runoff would stop at a level of excess reserves some increment above the Fed’s best estimate of the “right” level, then let the growth in currency achieve the final bit of contraction in excess reserves.  Think of this as the monetary policy analog of when your Mom bought your clothes a size too big with the expectation that you would “grow into them.”

Broadly, caution is a wise strategy as we approach the “right” level of excess reserves from above.  There is no particular downside to being slightly too high, whereas if the Fed goes too far, it could disrupt the smooth operation of money markets, at least until it was able to recalibrate.  Thus, it makes sense that the FOMC is leaning toward erring on the side of abundant reserves.  Even if the consensus view is that the “right” number is $1 trillion, as President Williams said, the FOMC may choose to stop runoff at $1.2 trillion or thereabouts, just to be safe.

While $1.2 trillion may not be the ultimate proper level of excess reserves, there is clear logic to stopping somewhere in that vicinity.  At the current runoff pace of about $120 billion per quarter, and currency growth of about $20 billion per quarter, excess reserves could be approaching $1.2 trillion in November or December of this year. That feels like a pretty reasonable baseline expectation for the moment for the timetable of a Fed halt to balance sheet normalization.  Note that it satisfies the guidance from the January FOMC minutes for “later this year”, but is still far less aggressive than the market analysts projecting an end to runoff within the next few months.

Stage two of balance sheet normalization

While market participants have been fixated on the Fed ending runoff, few have thought much about what the “new normal” will be once the Fed right-sizes the balance sheet.  The FOMC in the January minutes reaffirmed the notion that the Fed’s security holdings should be Treasuries only in the long run. There was not even any debate on that point.  Consequently, once the Fed stops shrinking the balance sheet, stage two of normalization will consist of continuing to run down MBS holdings and replacing them with Treasuries. The  Fed will continue to buy more Treasuries over time to track the growth in currency in order to maintain the “right” level for excess reserves.

One of the more interesting aspects of the January FOMC minutes discussion was on the topic of how quickly to try to draw down MBS holdings.  While there was no talk of outright sales, some policymakers were in favor of lifting the monthly cap on the pace of MBS runoff.  While the cap is highly unlikely to be binding any time soon, if MBS were by some chance to roll off more quickly than $20 billion per month, at least some on the FOMC were inclined to let that happen.  Since those securities would be replaced by Treasuries, there would not be a worry, as there would be today if caps were lifted, that too much monetary tightening was occurring.

In any case, this is a remote scenario, but it underscores the broader point.  Once the balance sheet gets to the desired size, not much will change for the MBS market.  The Fed will continue to allow rolloff as fast as they can practically achieve it.  Given that the Fed’s MBS portfolio will still be somewhere in the neighborhood of $1.5 trillion by late this year, that implies an ongoing drag on that market from passive reductions by the Fed for years to come (or until the next time that the FOMC decides to do QE).

In contrast, the Fed’s operations in the Treasury market will reverse. Rather than shrinking their holdings by about $20 billion per month, the Fed will be buying Treasuries to replace MBS runoff and to support the growth in demand for currency.  That will ultimately add up to a net increase in Fed Treasury purchases of about $40 billion per month (from -$20 billion to +$20 billion), enough to make quite a splash even in the massive Treasury market.  The increment from -$20 billion to zero will be achieved by rolling over all maturing holdings into add-ons in Treasury auctions, while the increment from zero to +$20 billion will presumably involve the reintroduction of old school coupon and bill passes.

The January FOMC minutes did not explicitly address the desired duration mix of the Fed’s Treasury portfolio, but before the crisis, the Fed held about half of its Treasuries in bills and half in coupons.  When the Fed begins to conduct passes to buy securities, it will want to be heavily involved in bills as a means to make the portfolio more liquid.  Past history with coupon passes suggests that the Fed would be buying mostly off-the-run issues, which could dramatically alter the trading dynamics for those securities.

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