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Fed Balance Sheet Normalization: When Boring Is Good

Bonnie M. Wongtrakool
Portfolio Manager


[Fed balance sheet normalization] will be the policy equivalent of watching paint dry. ~Patrick Harker, President, Federal Reserve Bank of Philadelphia1
Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas. ~Paul Samuelson, Economist and Nobel Prize Winner

Executive Summary

  • After years of extraordinary monetary policy efforts, the Fed has communicated a plan to normalize its balance sheet later this year.
  • Western Asset believes the Fed has designed a program that can indeed “run quietly in the background” and that the resulting Treasury and MBS supply will not disrupt markets.
  • We expect MBS to outperform USTs over the next nine months to a year, in light of the Fed’s measured pace of normalization, spread widening that has already occurred, and value relative to other asset classes.

Introduction

At the start of 2017, Federal Reserve (Fed) members began sharing their views on the Fed’s balance sheet with increasing frequency. This renewed attention to balance sheet normalization brought back memories of the 2013 “taper tantrum,” with some investors warning that the Fed’s exit from the Treasury (UST) and mortgage-backed securities (MBS) markets would result in a sharp rise in term premium, steepening of the yield curve, and widening in mortgage spreads. At Western Asset we had a more sanguine outlook, as we expected the Fed to take a cautious, gradual and well-communicated approach to reducing its purchases, and we believed that MBS valuations already reflected the downside risks of a Fed exit (see As Fed Reinvestments End, New Opportunities Arise for Bond Investors, March 28, 2017).

The Fed’s discussions culminated at its June meeting, when it reiterated its intent to start balance sheet normalization this year and further detailed the mechanics of its plan for reducing the balance sheet in an Addendum to the Policy Normalization Principles and Plans. Under this plan, the Fed will initially reduce its monthly MBS and Treasury reinvestments by no more than $4 billion and $6 billion, respectively. If runoff falls short of the caps in any month, the Fed will not sell the difference; if, however, runoff exceeds the caps in any month, the Fed will reinvest the difference. Every three months, it will increase the monthly MBS and UST caps by $4 billion and $6 billion until they reach $20 billion and $30 billion, 12 months later (Exhibit 1). Assuming that economic and financial conditions hold, we believe the tapering program will begin in September or December, in line with market expectations.

Exhibit 1
Scheduled Runoff of Treasury SOMA (System Open Market Account) Holdings
Source: RBC, Federal Reserve Bank of New York.

Market Impact

At the start of 2017, Federal Reserve (Fed) members began sharing their views on the Fed’s balance sheet with increasing frequency. This renewed attention to balance sheet normalization brought back memories of the 2013 “taper tantrum,” with some investors warning that the Fed’s exit from the Treasury (UST) and mortgage-backed securities (MBS) markets would result in a sharp rise in term premium, steepening of the yield curve, and widening in mortgage spreads. At Western Asset we had a more sanguine outlook, as we expected the Fed to take a cautious, gradual and well-communicated approach to reducing its purchases, and we believed that MBS valuations already reflected the downside risks of a Fed exit (see As Fed Reinvestments End, New Opportunities Arise for Bond Investors, March 28, 2017).

The Fed’s discussions culminated at its June meeting, when it reiterated its intent to start balance sheet normalization this year and further detailed the mechanics of its plan for reducing the balance sheet in an Addendum to the Policy Normalization Principles and Plans. Under this plan, the Fed will initially reduce its monthly MBS and Treasury reinvestments by no more than $4 billion and $6 billion, respectively. If runoff falls short of the caps in any month, the Fed will not sell the difference; if, however, runoff exceeds the caps in any month, the Fed will reinvest the difference. Every three months, it will increase the monthly MBS and UST caps by $4 billion and $6 billion until they reach $20 billion and $30 billion, 12 months later (Exhibit 1). Assuming that economic and financial conditions hold, we believe the tapering program will begin in September or December, in line with market expectations.

Exhibit 2
Estimated* Annual Supply of Treasuries and MBS from Fed Balance Sheet Normalization (USD Billions)
Source: BAML. *Assumes 30-year primary mortgage rate of 4% and that reduction in Fed reinvestments begins in October 2017.

At the start of 2017, Federal Reserve (Fed) members began sharing their views on the Fed’s balance sheet with increasing frequency. This renewed attention to balance sheet normalization brought back memories of the 2013 “taper tantrum,” with some investors warning that the Fed’s exit from the Treasury (UST) and mortgage-backed securities (MBS) markets would result in a sharp rise in term premium, steepening of the yield curve, and widening in mortgage spreads. At Western Asset we had a more sanguine outlook, as we expected the Fed to take a cautious, gradual and well-communicated approach to reducing its purchases, and we believed that MBS valuations already reflected the downside risks of a Fed exit (see As Fed Reinvestments End, New Opportunities Arise for Bond Investors, March 28, 2017).

The Fed’s discussions culminated at its June meeting, when it reiterated its intent to start balance sheet normalization this year and further detailed the mechanics of its plan for reducing the balance sheet in an Addendum to the Policy Normalization Principles and Plans. Under this plan, the Fed will initially reduce its monthly MBS and Treasury reinvestments by no more than $4 billion and $6 billion, respectively. If runoff falls short of the caps in any month, the Fed will not sell the difference; if, however, runoff exceeds the caps in any month, the Fed will reinvest the difference. Every three months, it will increase the monthly MBS and UST caps by $4 billion and $6 billion until they reach $20 billion and $30 billion, 12 months later (Exhibit 1). Assuming that economic and financial conditions hold, we believe the tapering program will begin in September or December, in line with market expectations.

Exhibit 3
Treasury Bills and Money Market Funds
Source: Bloomberg, Western Asset. As of 30 Jun 17

At the start of 2017, Federal Reserve (Fed) members began sharing their views on the Fed’s balance sheet with increasing frequency. This renewed attention to balance sheet normalization brought back memories of the 2013 “taper tantrum,” with some investors warning that the Fed’s exit from the Treasury (UST) and mortgage-backed securities (MBS) markets would result in a sharp rise in term premium, steepening of the yield curve, and widening in mortgage spreads. At Western Asset we had a more sanguine outlook, as we expected the Fed to take a cautious, gradual and well-communicated approach to reducing its purchases, and we believed that MBS valuations already reflected the downside risks of a Fed exit (see As Fed Reinvestments End, New Opportunities Arise for Bond Investors, March 28, 2017).

The Fed’s discussions culminated at its June meeting, when it reiterated its intent to start balance sheet normalization this year and further detailed the mechanics of its plan for reducing the balance sheet in an Addendum to the Policy Normalization Principles and Plans. Under this plan, the Fed will initially reduce its monthly MBS and Treasury reinvestments by no more than $4 billion and $6 billion, respectively. If runoff falls short of the caps in any month, the Fed will not sell the difference; if, however, runoff exceeds the caps in any month, the Fed will reinvest the difference. Every three months, it will increase the monthly MBS and UST caps by $4 billion and $6 billion until they reach $20 billion and $30 billion, 12 months later (Exhibit 1). Assuming that economic and financial conditions hold, we believe the tapering program will begin in September or December, in line with market expectations.

Conclusion and Investment Implications

At the start of 2017, Federal Reserve (Fed) members began sharing their views on the Fed’s balance sheet with increasing frequency. This renewed attention to balance sheet normalization brought back memories of the 2013 “taper tantrum,” with some investors warning that the Fed’s exit from the Treasury (UST) and mortgage-backed securities (MBS) markets would result in a sharp rise in term premium, steepening of the yield curve, and widening in mortgage spreads. At Western Asset we had a more sanguine outlook, as we expected the Fed to take a cautious, gradual and well-communicated approach to reducing its purchases, and we believed that MBS valuations already reflected the downside risks of a Fed exit (see As Fed Reinvestments End, New Opportunities Arise for Bond Investors, March 28, 2017).

The Fed’s discussions culminated at its June meeting, when it reiterated its intent to start balance sheet normalization this year and further detailed the mechanics of its plan for reducing the balance sheet in an Addendum to the Policy Normalization Principles and Plans. Under this plan, the Fed will initially reduce its monthly MBS and Treasury reinvestments by no more than $4 billion and $6 billion, respectively. If runoff falls short of the caps in any month, the Fed will not sell the difference; if, however, runoff exceeds the caps in any month, the Fed will reinvest the difference. Every three months, it will increase the monthly MBS and UST caps by $4 billion and $6 billion until they reach $20 billion and $30 billion, 12 months later (Exhibit 1). Assuming that economic and financial conditions hold, we believe the tapering program will begin in September or December, in line with market expectations.

Endnotes

  1. “Economic Outlook: The Labor Market, Rates, and the Balance Sheet,” May 23, 2017, https://www.philadelphiafed.org/publications/speeches/harker/2017/05-23-17-economic-outlook-the-labor-market-rates-and-the-balance-sheet.
  2. Chair of the Board of Governors of the Federal Reserve System Janet Yellen, post-FOMC decision press conference, June 14, 2017, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20170614.pdf.
  3. Projections for the SOMA Portfolio and Net Income, Federal Reserve Bank of New York, July 2017, https://www.newyorkfed.org/medialibrary/media/markets/omo/SOMAPortfolio
    andIncomeProjections_July2017Update.pdf
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