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The recent strength in the U.S. economy, combined with a government that’s not a big fan of easy monetary policies have brought talks of the Fed unwinding its balance sheet back in the spotlight.

What the heck is that all about and why should forex traders care? Here’s a simple Q&A for you!

What does a “balance sheet” look like for the Fed?

Just like any other balance sheet, the Federal Reserve keeps tabs on its assets and liabilities. In the Fed’s case, its assets include (but are not limited to) U.S. Treasury securities, mortgage-backed securities, lending to other institutions, and other currencies.

Meanwhile, its liabilities are mostly made up of the deposits of thousands of institutions and the value of the U.S. paper currency in circulation.

Unlike other institutions, though, there’s virtually no limit to the amount of assets that the Fed could gobble up. And in November 2008, then Fed Governor Ben Bernanke and his gang have decided to avail of this perk.

Why did the Fed expand its balance sheet?

In late 2008, the Fed started helping the economy claw back up from a financial crisis by buying boatloads of U.S. Treasuries and government-supported mortgage-backed securities.

This served several purposes. First, buying government bonds kept yields low, which made it easier for the government to finance its debts and institutions to borrow money.

On top of that, it also encouraged investors to put their money on riskier but higher-yielding assets like equities. Meanwhile, buying mortgage-backed securities made it easier for home buyers to take loans.

This went on for six years until October 2014 when new Fed Governor Janet Yellen announced the end of the bond-buying program.

By reinvesting principal payments and maturing securities, the Fed’s balance sheet has steadied at around $4.5 trillion. Latest Fed estimates put the value of Treasuries at $2.5 trillion while mortgage-backed securities holdings are valued at $1.8 trillion.

Why should they unwind?

Now that the economy looks like it’s firmly on its way to recovery, the Fed is facing more pressure to address its bloated balance sheet.

Some believe that the Fed’s large bond holdings are causing market distortions, while buying mortgage-backed securities gives unfair advantage to the housing market. Moreover, continued bond purchases could encourage market players to take on more risks than they should.

Last but not the least, additional incentive for the Fed to lighten up is pressure from the White House. Recall that Trump isn’t a fan of the Fed’s bond purchases, saying that it made it easier for the government to rack up budget deficits. By reducing its balance sheet, the Fed could avoid some of the heat and avoid a more direct challenge to its political independence.

What are the Fed’s options?

There are two popular options going around market circles. First is the direct selling of securities, which would directly (and aggressively) reduce the Fed’s assets.

Problem is, selling securities would put too much pressure on the bond market too quickly and could lead to unwelcome volatility and rapid increases of interest rates.

And then there’s the more chill approach of reducing assets by letting its securities reach maturity. Instead of reinvesting principal payments as it’s currently doing, the Fed could allow the bonds to “roll off” from its ledgers.

One catch to this approach is that $1.4 trillion of the $2.5 trillion worth of Treasuries is scheduled to mature in five years or less, with around $777 billion set to mature in 2018 and 2019. That’s still pretty quick, don’t you think?

What’s the Fed’s current plan of action?

Back in December, the Fed shared that it won’t unwind its balance sheet until “normalization of the level of the federal funds rate is well under way.” It didn’t change its tune until March, when the meeting minutes reflected that (emphasis mine):

“…policymakers discussed the likely level of the federal funds rate when a change in the Committee’s reinvestment policy would be appropriate. Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year.

Fast forward three months later and now we have a clearer plan.

In their June statement, Fed members shared that they expect to “begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.

If their May meeting minutes is any guide, the plan involves:

“…gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month.

As the caps increased, reinvestments would decline, and the monthly reductions in the Federal Reserve’s securities holdings would become larger. The caps would initially be set at low levels and then be raised every three months, over a set period of time, to their fully phased-in levels.

The final values of the caps would then be maintained until the size of the balance sheet was normalized.”

Basically, the Fed would limit the amount of bonds that it will allow to “roll off” each month. It would then raise its limits every three months, which means less and less money being reinvested into the markets and a faster pace of unwinding for the Fed.

The minutes revealed that “nearly all policymakers expressed a favorable view of this general approach” because it would reduce the Fed’s balance sheet in a “gradual and predictable manner” and “could help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates.

The Fed added deets to the plan in its June statement. We now know that:

  • The initial cap for payments from maturing Treasury securities is $6B per month, which will increase by $6B every three months for a year until it reaches a cap of $30B per month.
  • Payments from agency debt and mortgage-backed securities is capped at $4B per month, which will increase by $4B every three months for a year until it reaches $20B per month.
  • The maximum caps will remain in place “until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.
  • The Fed’s end game is a balance sheet level that’s “below that seen in recent years but larger than before the financial crisis.
  • The Fed could resume its bond-buying if there’s “material deterioration in the economic outlook” and could alter the size and composition of its balance sheet if “economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

Putting it all together

If there’s anything the 2013 “Taper Tantrum” has taught us, it’s that any big plans to reduce monetary stimulus should be communicated well and in advance.

Fundamentally, it makes sense for the Fed to start significantly reducing its balance sheet. But since this has never been done before, Yellen and her gang would have to tread carefully to avoid uncertainty and unwanted volatility in the financial markets.

For now, it looks like the Fed is doing pretty well in communicating their plans. We know that the unwinding will happen through controlling reinvestments; the caps for each major asset, and the conditions that might affect the Fed’s plans. That’s a pretty good start, don’t you think?