The Fed is now reducing the balance sheet by $95 billion a month

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The Federal Reserve is making headlines for raising interest rates at the fastest pace in a single year since the 1980s, worrying investors and consumers who fear the central bank is going too far, too far quick.

But this is another lesser-known, albeit much more complex, decision that could have an even greater influence on the cost of a loan. And everything is racing this month.

Over a three-month period, the Fed let $47.5 billion in assets every 30 days flow out of its massive bond portfolio of nearly $9 trillion, more formally known as the balance sheet. But starting in September, the Fed sped the process up a notch, doubling the number of Treasuries and mortgage-backed securities to $95 billion.

Why is the reduction in the Fed’s balance sheet important?

It’s the antithesis of the Fed’s massive bond-buying campaign during the coronavirus pandemic. Through three different programs, the Fed has amassed nearly $4.6 trillion in assets such as Treasuries and mortgage-backed securities. These measures have bolstered liquidity and kept the system awash with credit, helping to push interest rates on products the Fed doesn’t normally directly control — including things like mortgages and student loans — at floor levels.

But what goes down must go up. Experts say shrinking the balance sheet could be just another lever pushing interest rates higher. This is because stress effectively reduces the money supply and the availability of credit in the financial system.

This month’s surge could be one of many factors behind 30-year fixed-rate mortgages surging to 6.12, the highest level since November 2008, the data shows. National Bankrate. An indication of the extent of further tightening of the Fed’s balance sheet: the spread between the 10-year Treasury yield and the 30-year fixed-rate mortgage is nearly a percentage point higher than this that it should be, according to Lawrence Yun, chief economist at the National Association of Realtors.

“With the Fed being a big liquidity provider and not being around anymore, mortgage rates are even higher,” he says.

It’s a sacrifice the Fed is willing to make to help calm rapid inflation that has spent six straight months at levels not seen since the 1980s. The process is often referred to as quantitative tightening.

“It’s also another way the Fed is stepping on the brakes in an effort to slow the economy and reduce inflation,” said Greg McBride, CFA, chief financial analyst at Bankrate. “Over time, this will have more impact than raising short-term rates.”

This decision would have major implications for the cost to consumers of financing major life events, from buying a house or a car to college.

If things go according to plan, the Fed will have withdrawn more than $522 billion from the financial system by the end of 2022 and another $1.1 trillion by the end of 2023. Cutting $1.5 trillion from dollars from the Fed’s portfolio is equivalent to raising interest rates by up to 1 additional percentage point, according to estimates by Luis Alvarado, vice president and investment strategy analyst at the Wells Fargo Investment Institute.

“We understand what the Fed did at the height of the pandemic in March 2020 when everyone was scared,” Alvarado says. Fed officials, however, don’t want to “have big balance sheets. They want to have parallel balance sheets based on economic growth.

How much will interest rates rise as the Fed shrinks its balance sheet?

The big question mark is whether the officials will have enough room on the track to make it happen.

The Fed has only ventured down this path once before: when the economy was recovering from the Great Recession of 2007-2009. At the time, they managed to suck roughly $700 billion out of the system, or just 20% of what they bought, before the financial markets seized up and the economy risked plunging.

At the Fed’s current pace, the Fed’s balance sheet would reach its pre-pandemic size of $4.3 trillion about four years from June 2022. But a lot can change in the economy by then — and a lot can also go wrong enough for Fed officials to call off the mission.

So far, the Fed has dumped about $133 billion of bonds. Investors will likely wait for more clues from the Fed at its final rate-setting meetings in 2022 for clarity on how far officials think they can go in the process.

“I don’t think the Fed can take too many trillions out of the system without something happening overnight,” McBride said. “If the economy weakens, eventually they will ease policy or the pace of quantitative tightening.”

The Fed’s inflation-fighting plan is unlike any other in recent history

The Fed’s latest foray into reducing the money supply was also very different from today’s experience, with another layer unclear how much of an impact consumers might feel. The Fed waited almost two years to start selling bonds after raising interest rates for the first time after the December 2015 financial crisis. This time the Fed waited only three months after its first hike rates to start reducing its holdings.

Not only that, but officials had previously opted to gradually increase the number of bonds they would let out of their portfolio over a 12-month period, until it eventually reached $50 billion a month. Today, the Fed is moving four times faster and its monthly cap is almost twice as high.

Have the biggest rate increases already happened?

In an unprecedented move, mortgage rates have risen sharply in a very short time. That’s largely because the 10-year Treasury yield – the main benchmark for the 30-year fixed rate mortgage – has also soared.

A year ago, the benchmark 30-year fixed-rate mortgage was 3.03%, while the 10-year Treasury yield was 1.31%. Typically, the gap between the two should be around 170 basis points, according to Yun of the National Association of Realtors.

Today, however, the key bond yield is 3.45%, the highest since 2011, 267 basis points above the average 30-year fixed-rate mortgage.

That signals that the sub-5% mortgage rates that consumers enjoyed for more than a decade — plus an eight-week stretch in 2018 — are all but in the rearview mirror, according to McBride.

“When the biggest buyer in the market leaves the table, it creates a vacuum,” he says. “There must be investors to fill this void, otherwise prices could fall sharply and rates could rise significantly in order to attract enough investor demand.”

It’s too early to tell what exactly happens with interest rates from here, but some experts say the biggest jumps may have already happened, as evidenced by the fact that rate hikes the Fed’s benchmark federal funds are now catching up with rising mortgage rates.

“We know the Fed will continue to tighten, both on the fed funds rate and on the unwinding of quantitative easing,” Yun said. “But hopefully the market has already priced in all of that, so maybe this time next year mortgage rates will be the same, even if the Fed continues to tighten policy.”

The 10-year Treasury rate could fall even if the Fed raises rates, especially if investors anticipate an economic slowdown or lower inflation. The policy rate erased nearly half of its gains in the previous Fed tightening cycle, starting with the Fed’s first rate hike on December 16, 2015 and ending when officials stopped shrinking the balance sheet on September 30, 2019. Technically speaking, it is only up 62 basis points.

“That’s what happens most of the time when the Fed tightens policy,” McBride says.

Other Factors That May Affect Interest Rates

The impact on the consumer also depends on more technical reasons. When the Fed reduces its balance sheet, it does not sell these securities; instead, he simply lets those bonds roll to maturity without reinvesting his principal payments.

Still, some pundits have pointed out that the Fed may struggle to meet the quota it has set for mortgage-backed securities. If so, they might have to sell those assets for the first time in Fed history, which would have even bigger implications for mortgage rates. The massive stockpile of these Fed securities – $2.7 trillion – has undoubtedly kept the cost of financing a home from rising even further.

And interestingly, only $43.6 billion of Treasuries are maturing this month, which means the Fed will have to look to $16.36 billion of short-term Treasuries for reach their full monthly cap.

Fed officials indicated in the minutes of the January and March Fed meetings that this strategy “may be appropriate at some point in the future”, so that the Fed can move towards a portfolio of longer-term bonds “composed primarily of Treasury securities”. Top Fed officials have also said the approach could be an even more aggressive relief plan if inflation remains elevated.

Selling assets also exposes the Fed to another risk it has so far been able to dodge: incurring a loss.

At the end of the line

Less money lying around in the financial system tightens financial conditions overall. This could cause companies to delay any new investment, including hiring. The most pessimistic scenario is an increase in unemployment.

All of this goes to show that the contraction in the Fed’s balance sheet is a major factor to watch going forward – and also a reason to focus on building up your emergency fund.

Another group caught in the crossfire could be investors. The Fed’s plans to unwind its balance sheet contributed to the year’s volatile financial conditions, with the S&P 500 down more than 19% to start the year.

Keep a long view and turn a deaf ear: the Fed’s overarching goal is to get monetary policy on track to a more sustainable level that paves the way for a long and lasting expansion and eliminates pressures massive on financial market prices. system.

Still, the Fed’s balance sheet reduction is a major unknown, and only with hindsight will investors and consumers be able to judge its full impact.

“It’s the Wild West of monetary policy,” says Kristina Hooper, chief global market strategist at Invesco. “We are in the country of experimental monetary policy. We just don’t know how it’s going to pan out. »

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