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Commentaries

PMC Weekly Review - September 22, 2017

A Macro View: Impact of the Fed’s Decision to Reduce Its Balance Sheet

As was widely expected, the Federal Reserve (the Fed) on Wednesday announced no change in the target Federal Funds rate but did signal its intent to begin reducing the size of its balance sheet beginning next month. The plan, as laid out in June, will allow roughly $6 billion in treasury securities and $4 billion in agency debt and agency MBS per month to mature, without reinvesting the proceeds. This amount is currently set to increase by an additional $10 billion per quarter (in the same ratio) until the total reaches $50 billion in the fourth quarter of 2018. All of this remains heavily data dependent, of course. Similar to the tapering of the Fed’s quantitative easing (QE) purchases in 2014, this decision will take a significant, and importantly, price insensitive buyer out of the market, at least partially. What has been widely speculated upon for months is what impact this will have on the agency mortgage-backed securities (MBS) market directly, and, indirectly, on the housing market and the remainder of the investment grade spread sectors.

It might be assumed that reducing the balance sheet would have the opposite impact of the accumulation of these securities since 2009. The Fed’s quantitative easing program (QE1, QE2, QE3, Operation Twist, etc.) was intended to keep interest rates low by “crowding out” investors in the treasury and agency MBS markets, encouraging them to seek higher yields in corporate debt and the equity markets. The agency MBS purchases also kept mortgage rates low, encouraging individuals to continue buying homes. The latter impact was arguably severely minimized in the first few years by much tighter loan qualification standards in the wake of the mortgage crisis at the heart of the 2008 collapse. So should we see higher interest rates and higher mortgage rates resulting from this reduction? Given the amount being allowed to mature is significantly less than the Fed’s purchases (up to $85 billion/month in 2013), any upward pressure on rates should be proportionately smaller than the downward rate movements caused by the QE purchases.

The partial removal of a price insensitive buyer from the agency MBS market will have some effect on that market directly. But it is only a partial removal, as the Fed’s reinvestment purchases in the agency MBS market have averaged $25 billion per month so far in 20171. Even if every step of the proposed plan is executed on schedule, the Fed will still be buying roughly $5 billion in agency MBS per month at the end of 2018. Although the Fed is the only price insensitive buyer in this market (we hope), there is every reason to assume the demand for these securities will be filled by any number of other buyers, including non-US buyers seeking much higher yields than their local sovereign bonds, while still being backed by the full faith and credit of the US government. Any widening of spreads based on supply and demand should be small and temporary.

In short, the impact of the Fed’s announcement on Wednesday should be negligible over the next six to nine months. The plan has been well telegraphed and explained to the market, limiting any shock effect similar to the taper tantrum in 2013. The size of the reductions is small in relation to the pace at which the securities were acquired, and the pace of the increase is incremental enough to allow supply and demand for the securities to remain in relative equilibrium. Finally, demand for high-quality securities with relatively decent yields (globally speaking) should sharply limit any increase in spreads or yields.

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1 Per the NY Fed Open Market Trading Desk monthly publication, including anticipated purchases in September.

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