The Federal Reserve’s Balance Sheet is currently $4.5trn, thanks to the QE programme which at one point involved pumping $85bn a month into the financial system. The US economy is now widely regarded to be in a recovery stage after the Great Recession in 2008, where employment is up 4%, and economic growth has risen to 2% annually, in line with trends.
Already, the Fed has shown boldness in deciding to raise the benchmark interest rate for three consecutive quarters, but now the next stage of monetary tightening involves reducing the size of the balance sheet assets through offloading some of its bonds by the end of the year. However, there are significant fears over the consequences for financial markets if the Fed acts too unpredictably by selling lots of bonds in one go or raising the interest rate too quickly.
Economists cannot forget 2005-6: the base rate was increased from 1.25% to 5.25% over 17 months, which eventually led to the wave of mortgage defaults across the USA preceding the Banking Crisis of 2007-8. No central banker wants a repeat of the crisis; therefore, the course of monetary policy going forward in the recovery stage of major economies needs to be employed with caution and more importantly, with direction.
Implications of Policy Tightening
The yield curve has flattened, which implies a shrinking premium spread between the short and medium term bonds (1-10 year) and the 30-year bonds. The lack of inflation has led to a decline in bond yields for long-term bonds since investors are less fearful about their money losing purchasing power over the years, implying an expectation of continuity in low inflation.
In fact, the current spread suggests investors expect inflation in the U.S. to run at an annualised 1.86% rate over the next three decades, at this point in time. The low inflation of 1.4% and consequent fall in yield spreads can imply that investors do not expect the Fed to raise interest rates by a huge degree for now unless inflation starts to spiral out of control. Balance sheet reduction is another part of contemporary monetary policy, whereby the Federal Reserve and ECB would unload some of the trillions in bonds acquired during the Quantitative Easing programme.
The central banks have already witnessed one of the main risks: the prospect of a mass selloff and rise in bond yields across the maturity spectrum. Following Draghi‘s hint that the ECB will start selling off its holdings back to the market, Italian 10 year bonds were hardest hit on the day with yields rising from 1.846% to 2.053%; many US observers believe this is only a taster of what could come when the Federal Reserve starts selling its bonds later this year.
Here, it is important to stress that central banks have two options: they can either sell off in the secondary market in this manner, or they can simply not reinvest all the proceeds received from maturing bonds each month.
There has been an argument that selling bonds back to the market can be good from a market collateral point of view. Banks lend to each other on overnight repurchase agreements (repos), which pay a higher interest than deposits or T-Bills. On a repo though, they must offer collateral, often at a 40%+ higher value than that of the loan taken out; this collateral used to be in the form of mortgage backed securities back in 2008 but now the securities collateral reuse rate is down three times since the Lehman collapse.
Therefore, according to Manmohan Singh from the IMF, the best collateral to offer is T-Bills, which are also in shorter supply than analysts believe is necessary to maintain money flows through the financial system and to the real economy. The imminent selling of bonds back to the market will thus give financial institutions a larger level of collateral which can allow them to obtain more financing and increase lending facilities to the public, especially as interest rates are now on the rise.
Currently, banks hold >$2trn of excess reserves, in part to shore up their capital base and reduce debt/capital ratios in line with regulations. A reduction in bond holdings by the central bank can result in a decrease in the excess reserves held by banks and a rise in total bond assets held by banks (a reverse accounting entry to 2009).
In contrast to the ECB however, Yellen however, has hinted at a possibility of a gradual reduction in holdings rather than a selloff to the markets; this involves reinvesting only a portion of the maturity proceeds received each month.
This portion or cap will then be increased every three months, although the Fed has not made it clear on the exact cap amounts or the acceleration of decline in reinvestments. This is less risky for bond markets due to a lower probability of disruption created i.e. no flooding of the market with bonds means no collapse in prices.
However, the risk that the Federal Reserve may unload too quickly over the 6-12 months following the start of the programme can be enough to spook investors that prices may collapse, especially given the expected increase in baseline interest rates next year. Even using a reinvestment policy can spark fear of a price collapse due to the periodic reduction in demand for bonds by the Central Bank (in billions of dollars).
Yellen has announced that the first cap will likely be $6bn in T-Bills (i.e. $6bn not reinvested in bond markets following maturity). The fear is that this number can rise all too quickly, creating shortages of demand in the market at times when investors usually expect buoyancy; a fall in prices can result.
This fear was responsible for the selloff at the end of June after Draghi’s comments on reflationary forces in the Eurozone, even though no tapering in policy was actually announced. As we observed, this creates a self-fulfilling equilibrium of a run to safety where a large number of investors indulge in panic selling, in order to obtain cash. This is why it is imperative for the Fed to announce clear direction of monetary policy to the markets to avert such a crash.