Fed Plans To Trim Its Massive $4.5 Trillion Balance Sheet

By Gary D. Halbert. Originally published at ValueWalk.

FORECASTS & TRENDS E-LETTER

by Gary D. Halbert

June 20, 2017

1. Fed to Reduce Massive $4.5 Trillion Balance Sheet – Implications
2. How the Fed Got to $4.5 Trillion & Is There a Way Out?
3. Fed Announces Controversial Plan to Reduce Its Balance Sheet
4. Unwind Timeline & Implications For the Markets & Economy
5. Conclusions: Markets Don’t Like Uncertainty

Fed to Reduce Massive $4.5 Trillion Balance Sheet – Implications

Most investors understand the implications of the Fed raising (or lowering) interest rates. After lowering short-term interest rates to near zero in late 2008, and keeping them there for eight years, the Fed is now committed to “normalizing” short-term rates by raising the key Fed Funds rate multiple times over the next couple of years.

Starting back in March, and more specifically at the May meeting, the Fed also began to talk about reducing the size of its “balance sheet” which today consists of apprx. $4.5 trillion in US Treasury bonds and mortgage-backed securities. My impression is that many investors don’t fully understand what reducing the balance sheet entails, but it is very important. I’ll try to explain it and the market implications as we go along today.

Let’s begin by going back to 2007 before the financial crisis and the Great Recession unfolded. In late 2007, the Fed Funds rate was above 5% – before the Fed embarked on its Zero Interest Rate Policy (ZIRP). Within about a year, the Fed slashed its key short-term rate to near zero and kept it there until late 2016 when it began increasing it.

In addition to raising and lowering short-term interest rates, the Fed can also increase or decrease its balance sheet of assets and liabilities. Since the Fed has the ability to “create money,” it can increase its balance sheet by virtually unlimited amounts.

To increase its balance sheet, the Fed has in recent years ballooned its purchases of US Treasury bonds and mortgage-backed securities. These purchases were intended to keep longer-term interest rates low and hopefully boost the economy.

In 2007, the Fed’s balance sheet consisted of apprx. $800 billion of mostly Treasury bonds and to a much lesser extent mortgage-backed securities. Sounds huge, right? Yet since then, the Fed’s balance sheet has exploded to apprx. $4.5 trillion, which is nothing short of mind-boggling! Now the Fed says it wants to begin reducing this mountain of debt.

As I will explain below, I fear that this unwinding of the Fed’s balance sheet has much more serious implications for the US economy than the planned increases in the Fed Funds rate.

If the Fed gets this so-called “unwind” wrong, the fallout could be dramatic, including a sharp rise in interest rates, tumult in the stock and bond markets and maybe the next recession.

This is why ALL serious investors need to understand what the Fed is about to undertake.

How the Fed Got to $4.5 Trillion & Is There a Way Out?

I like the way CNBC columnist Jeff Cox introduced this topic to his audience recently:

“Consider the Federal Reserve the Starship Enterprise of monetary policy: It went where no central bank had gone before, and now must plot the journey home.”

As noted above, the Fed had less than $1 trillion ($800 billion) in reserves back in 2007 before the Great Recession and the financial crisis unfolded. Then in a series of three massive bond buys – known as “quantitative easing” (QE) – the Fed exploded its balance sheet by an incredible $3.7 trillion by 2009, thus bringing today’s total to $4.52 trillion.

Of the $3.7 trillion, just over 60% was US Treasuries with the rest in mortgage-backed securities (home loans packaged together as bonds). Both classes of bonds have various maturity dates. In the current policy, whenever bonds mature, the proceeds are reinvested (rolled over) in new bonds. This constant buying helps hold interest rates low.

This is where it gets tricky. Starting sometime later this year, the Fed says it will cease rolling over some of its maturing bonds each month, letting them disappear if you will. What this means is that the Fed will be reducing its monthly bond purchases, thereby reducing overall demand for these securities – which could cause bond yields to rise.

It’s a balancing act for the Fed to know how much less buying the bond markets can handle, without seeing yields rise significantly. The trouble is, Fed officials admit they have little clue how their actions will impact financial markets and, in turn, borrowing costs. Uncharted territory indeed!

Fed Announces Controversial Plan to Reduce Its Balance Sheet

At its May policy meeting, the Fed Open Market Committee (FOMC) discussed a detailed plan for reducing its monster balance sheet. The minutes of that May 2-3 meeting, and the details of the plan to reduce the balance sheet, were made public on May 24.

The so-called “unwind” plan is controversial and includes some significant potential risks that I do not believe are “priced-in” to the stock and bond markets yet. I’ll explain those risks below.

At the May meeting, the FOMC discussed a plan to begin unwinding part of its balance sheet later this year by initially letting $6 billion a month in maturing Treasuries run off – meaning they will not be reinvested – which will slowly increase over the coming months. Here’s what they said:

“For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.”

With regards to mortgage-backed securities (MBS), the Fed discussed a similar plan where it will begin tapering $4 billion a month and slowly increase that amount each quarter until it reaches $20 billion/month.

In total, the Fed will reduce bond purchases by $10 billion per month initially later this year, increasing to $50 billion per month by early 2019.

Additionally, the Fed said the long-run plan is to keep the balance sheet “appreciably below that seen in recent years but larger than before the financial crisis.” Interesting. As noted earlier, the Fed’s balance sheet was around $800 billion before the financial crisis. Now at $4.52 trillion, the Fed says it wants to reduce it ‘appreciably’ but keep it above where it was in 2007.

Understandably, this has led to a great deal of speculation among Fed-watchers. Does this mean the Fed wants to keep a balance sheet of at least $2 trillion on a permanent basis? Or $1.5 trillion? Or $2.5 trillion? We just don’t know.

What we do know is that by starting at $6 billion a month for Treasuries and $4 billion a month for mortgage-backed securities, it will take several years and maybe more for the Fed to reduce its bloated balance sheet to whatever level it is targeting.

Unwind Timeline & Implications For the Markets & Economy

I’m devoting a lot of space today to this discussion of the Fed’s upcoming plan to reduce its balance sheet for several reasons. First, of course, is the sheer size of the balance sheet at $4.5 trillion. No central bank in history has had a balance sheet remotely this large.

Second, obviously, is no central bank

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