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.

Download the full PDF 

This material is to be used for institutional investors and not for any other purpose. The enclosed information has been developed internally and/or obtained from sources believed to be reliable. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US Form ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate.

The information presented is for illustrative purposes only. Individual accounts may vary based on restrictions, substitutions, cash flows and other factors.

Specific sectors mentioned to not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell, or hold such securities. Aegon AM US products and strategies may or may not include the securities referenced and if such securities are included, there is no representation that such securities will continue to be included.

Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short-term trading strategy, guidelines for a particular client, and other variables.

There is no guarantee these investment or portfolio strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest over the long-term, especially during periods of increased market volatility.

This document contains "forward-looking statements," which are based on change to the firm's beliefs, as well as on a number of assumptions concerning future events based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein. In addition, this material contains information regarding market outlook, rates of return, market indicators and other statistical information that is not intended and should not be considered an indication of the results of any Aegon AM US-managed portfolio.

Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.

Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of this report without the prior written consent of Aegon Asset Management US, 4333 Edgewood Rd NE, Cedar Rapids, IA 52499. ©2018 Aegon Asset Management US. Adtrax Code: 2161462.1. Exp Date: 6/30/19.