In the wake of the global financial crisis of 2007 and 2008, when financial markets were in panic and stock prices were in freefall, the U.S. Federal Reserve took many aggressive and unprecedented measures to calm the markets and to reinvigorate the U.S. economy, which was falling into recession.
Among its first actions was to reduce its key interest rate, the federal funds rate. That rate, which had been set at 5.25% at the end of 2006, was cut three times in 2007 and seven more times in 2008, eventually reaching 0% at the end of that year, where it remained until the end of 2015.
With the fed funds rate already at zero and failing to improve market conditions, the Fed embarked on a more aggressive program known as "quantitative easing," which involved the purchase of trillions of dollars of government debt and government-insured mortgage-backed securities. The goal of the program was to reduce long-term interest rates, as the fed funds rate is only a short-term rate. QE, for short, was conducted in multiple stages as each previous phase failed to achieve the desired results, namely economic growth.
Before the recession, the Fed held between US$700 and US$800 billion of Treasury notes on its balance sheet, which it uses to conduct monetary policy. Over the next six years (2008-2014), the Fed increased the size of its portfolio to over US$4.5 trillion, where it still stood roughly at the end of 2017.
On 14 June 2017, the Fed announced it will begin reducing its portfolio holdings as the U.S. economy showed sustained growth. It will allow US$6 billion of Treasury securities to mature each month without replacing them, increasing the total by another US$6 billion a month until US$30 billion a month is being retired. The Fed will follow a similar process with its holdings of mortgage-backed securities, retiring an additional US$4 billion a month until it reaches a total of US$20 billion a month.
The Fed's decision to increase its portfolio to such an extent was unprecedented. Likewise, unwinding its massive portfolio to a figure more in line with historical levels (well below US$4.5 trillion) will also be unprecedented and may cause disruptions in the financial markets.
At US$4.5 trillion, the Fed's balance sheet is equivalent to about 25% of U.S. GDP. In 2007, before it began QE, its balance sheet equaled only about 6% of GDP. The Fed owns about US$2.5 trillion in U.S. Treasury securities, or about 18% of the amount held by the public. Its holdings of mortgage-backed securities total about US$1.8 trillion, or more than 25% of that market.
Potential Impact On Stock And Bond Prices
In addition to lowering long-term interest rates, another goal of the Fed's QE program was to push investors into riskier assets, namely stocks. Immediately after the financial crisis, many investors, both institutions and consumers, refused to take on any financial risk. Between mid-2007 and early 2009, U.S. stock prices plunged by nearly 50%. By buying up so many bonds, the Fed effectively reduced long-term interest rates to record lows, making them unattractive to investors, essentially forcing them to buy stocks if they wanted to earn positive returns.
Since then, stocks have rebounded sharply, more than tripling since the low point in March 2009. The Fed's purchases, therefore, have led to a huge increase in both bond and stock prices. To some observers, the Fed's massive purchases artificially inflated the price of bonds and stocks, creating asset bubbles. They are therefore concerned that any reduction in the Fed's portfolio may lead to a deflation in those asset prices, which could lead to sharply higher interest rates and massive stock losses.
The "Taper Tantrum"
There is a precedent for what may happen if the Fed starts unwinding its balance sheet.
In May 2013, then-Fed Chairman Ben Bernanke merely suggested that the Fed might soon start tapering its bond purchases. That led to a full-scale panic in the financial markets, with bond yields surging and stock prices falling in response. The yield on the 10-year Treasury note, the bond market's long-term benchmark, jumped more than 100 basis points to 3%. The episode came to be known as the "taper tantrum."
Calm was eventually restored, but not before investors lost a lot of money. As a result, any talk of the Fed reducing the size of its balance sheet has been met with varying levels of concern in the financial markets.
The Fed may have learned a lesson from the taper tantrum, namely that it can't suddenly surprise the market with a potentially devastating change of strategy. This time around, the Fed has been extremely cautious in announcing the details of the unwinding, and emphasized that reducing its portfolio will be done very gradually over the course of several years. But not everyone buys that argument.
"Fed Chair Janet Yellen assures us that once the process of reducing the Fed's portfolio gets underway, it will be as dull as watching paint dry," Desmond Lachman, a resident fellow at the American Enterprise Institute, said. "However, the truth of the matter is that she cannot possibly know what will happen once the Fed goes down this uncharted path. We simply have no historical experience of what happens when the Fed starts to reduce its balance sheet after having increased it on anywhere near the scale it has done over the past eight years."
"Should today's asset and credit market bubbles indeed burst next year, the process of Fed balance sheet unwinding will be anything but like watching paint dry," he added. "It also would be highly unlikely that the Fed would stick with its planned balance sheet reduction program for very long."
Higher Interest Rates
"While balance sheet reduction is expected to be gradual, the market may not have fully priced in a return to more 'normal' monetary policy, raising the risk of a jump in yields," said Kathy A. Jones, senior vice president and chief fixed-income strategist at the Schwab Center for Financial Research. "We see the potential for the unwinding of the Fed's balance sheet to increase 10-year Treasury bond yields by as much as one percentage point (or 100 basis points) all else being equal."
"We don't expect a repeat of the taper tantrum in the Treasury market because the plan has been so well-communicated," she added. "However, it's possible that there could be a more adverse reaction in the MBS market than in the Treasury market, because the Fed's buying has represented a bigger proportion of that market."
Jones raises another important issue. "What we don't know is the end point—how large the Fed would like the balance sheet to be when it stabilizes."
The prevailing opinion seems to be that the Fed eventually wants the portfolio to end up somewhere in the middle of where it started QE and where it ended, i.e., about US$2.7 trillion. However, that would still be more than three times its size before the financial crisis.
Impact On Bank Lending
Unwinding will also have an impact on the banking industry, both negative and positive.
By buying mortgage-backed securities and Treasuries from commercial banks in QE, the Fed added credit to the banks' reserve accounts. By shrinking its balance sheet, the Fed reduces the amount of reserves in the financial system, therefore lowering the amount of money banks have to lend to consumers and businesses. Such a move could cut deposit growth and disrupt other parts of the banking business, some believe.
"Exactly how much of a toll the unwinding process will take on banks is anyone's guess as the central bank has never attempted to shrink its balance sheet like this," American Banker reported on 31 July 2017. "Predictions range from there being little to no effect on banks, to a mad scramble for deposits to replace the lost liquidity."
That could mean that banks will either have to raise the interest rates they pay in order to attract new deposits—thus lowering their profit margins—or be content to sit and watch those deposits walk away, which means they have less money to lend and therefore lower revenue and lower profits.
However, the unwinding may also have a positive effect on bank profits. Bank deposits held at the Fed earn only the federal funds rate, which is basically the benchmark for all other short-term interest rates. By not having so much money parked at the Fed, banks stand to earn more—that is, if lending picks up.
If they don't lend out that money, they could instead buy Treasuries or mortgage-backed securities, i.e., the same securities that the Fed is no longer buying. That could mitigate any negative impact of the Fed's portfolio reduction.
The Fed's balance sheet unwinding may have negative effects on banks for another reason.
"The Fed's … desire to raise its short-term interest rate target before shrinking its balance sheet … could cause short-term interest rates to rise faster than long-term interest rates, a flattening of the yield curve. This would cause problems for financial firms that depend on the spread between these interest rates for profitability," noted David Beckworth, a senior research fellow at the Mercatus Center at George Mason University. "Banks, for example, generally earn more on their long-term home and auto loans than on the interest payments they make to their short-term depositors. If, however, short-term interest rates were to rise above long-term interest rates they could start losing money. Lending would be cut back."
The Fed's unwinding plan may run into another unforeseen problem going forward. Like the Fed, the world's other major central banks—notably the Bank of Japan, the European Central Bank and the Bank of England—conducted their own QE programs, often even larger than the Fed's purchases, at least relative to the size of their respective GDPs.
While those banks haven't yet started to unwind their own portfolios—indeed, the BOJ and the ECB are still in buying mode—that trend will eventually end as the world economy continues to recover. If all of those central banks start unwinding their massive portfolios at the same time, there could be major disruptions in the financial markets everywhere.
The U.S. Federal Reserve, which increased the size of its balance sheet from less than US$900 billion to more than US$4.5 trillion in order to fight the global financial crisis and keep financial markets stable, has begun the process of slowly reducing the size of its portfolio as the economy has recovered.
However, there is no historical precedent for a central bank to unwind such a massive portfolio. Although the Fed has promised the unwinding process will be slow and well-telegraphed, it could nevertheless lead to sharply higher interest rates that would upset the financial markets and the banking industry.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…