The Fed Unwind

By Francis P. Rybinski, CFA, Chief Macro Strategist & D. Harris Kere, CFA, Investment Strategist

A prominent conversation within the markets revolves around the Federal Reserve and how many times they will raise interest rates this cycle. However, there is another important question looming that gets much less attention—probably because the answer is much more nebulous: What will be the effect of the Fed's massive balance sheet reduction plan?

When the Fed's unwind program hits terminal velocity later this year, the balance sheet will be shrinking by $50 billion per month, comprised of $30 billion in Treasuries and $20 billion in mortgage-backed securities. This pace will remove an annual amount of $600 billion in liquidity in 2019 and again in 2020 (Exhibit 1). The annual pace is roughly equivalent to the entire federal budget deficit of fiscal 2016. That is quite a burdensome amount that must be funded by the private markets and thus takes from investment elsewhere, which would arguably have higher rates of return.

Exhibit 1: Fed Treasury and MBS rolloff schedule


Source: Federal Reserve Board

US monetary policy has never before experienced a tightening of this magnitude. Typically the monetary base growth is slowing as the Fed is raising interest rates, and is well contained when normalized to GDP (Exhibit 2a). Even former Fed Chair Janet Yellen used the word "hope" before discussing her desire that the program will have "very little market reaction" and will "run quietly in the background." (She then went on to say it will be like "watching paint dry" at the FOMC press conference on June 14, 2017.)

Exhibit 2a: Fed balance sheet as % of GDP, 1982-2006

Source: Federal Reserve Board, Aegon AM US Macro Strategy, Bloomberg

Exhibit 2b: Fed balance sheet as % of GDP, 2007 - 2020e,
An unprecedented projected decline in Fed balance sheet

Source: Fed Reserve Board, Aegon AM Macro Strategy, Bloomberg. Projections uses rolloff caps, Aegon AM US real GDP forecasts, and 2% inflation

The chorus of concern has already begun, having started with the head of the Central Bank of India whose comments were quickly echoed by the central bank of Indonesia. In short, their worries revolve around the stress that such a massive liquidity removal of dollar funding can have, especially in a heavily dollar-funded emerging market. Furthermore, if the velocity of the global economy peaks in 2018, as Aegon AM is forecasting, then this liquidity removal can potentially exacerbate a slowdown.

Concern about economic growth has the potential to eventually slow the pace of rate hikes by the Fed, making the lower end of a dot plot the more likely final destination. If faced with the choice of having to slow down either the balance sheet unwind or the pace of rate hikes, we believe the Fed will opt for the latter. In our view, the signaling effect from a change in the stated balance sheet plan would be viewed much more negatively than if the Fed's dot plot slid lower. In effect, the need to change the balance sheet plan would be interpreted as a sign of trouble by markets, perhaps signaling that the economy is not strong enough for a fully normalized policy. Conversely, the rates narrative is more fluid, especially as the upper bound of the current fed funds rate, now at 2.0%, is almost inside of the committees estimated range for the long-term rate funds rate, which is 2.25% to 3.50%.

We expect this narrative to pick up steam in the back half of the year when the balance sheet runoff pace reaches terminal velocity in the fourth quarter 2018 (Exhibit 2b). At that point, there may well be some gravitational pull on the Fed's dots, which will need to be repriced by the markets.

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