What the Fed really, really means

In short, the Fed will slowly shift away from its current policy of reinvesting in full principal payments from existing assets. As a result, its balance sheet contraction will begin gradually, accelerate for a period of time and then proceed at a constant rate until reaching a yet-to-be-determined “end” size. And this all assumes a new crisis does not loom over the horizon. This was not a big surprise, as the FOMC had telegraphed its plan to begin a gradual wind-down by 2018. What we do not know is:

1. How quickly balance sheet?

will

the Federal Reserve shrink

its

The caps will be welcomed by investors, but how high will the “don’t reinvest caps” ultimately be, and how soon will they be upped to their full levels?

2. What sized balance sheet will the Fed be left with?

Ben Bernanke has said the reduction need not be that big. Before 2008 the Fed kept tiny reserves compared to US currency in circulation. This was because its management of short rates relied on manipulating the level of scarce reserves available to banks. In 2008, it shifted to direct management of rates paid on those reserves — the so called floor system.

Going forward, the Fed may choose a level of reserves similar to the amount of currency in circulation, just as it did at the height of the crisis in December 2008. That quantity of reserves allowed short rates to be kept near zero, as targeted, despite financial stress.

Currency in circulation now stands at about $1.5 trln so if $1.5 trln of reserves is also desirable, the balance would be about $3 trln. This compares with a balance sheet today of about $4.5 trln. It follows that shrinkage may only need to be about $1.5 trln. Bernanke has argued that the US economy could easily grow into that sum within ten years, negating the need for a balance sheet reduction. Janet Yellen reportedly disagrees, and is pushing ahead with plans for a contraction. But she too may choose to dial back on the scale of that shrinkage.

3. Will the Fed accelerate the shift to a “clean” balance sheet?

The FOMC has stated a desire to get out of the dirty MBS business and back toward a “clean” balance sheet, just comprised of US treasuries. The minutes indicate it will start to phase out both reinvestments in MBS and treasuries. However, the Committee could yet accelerate its housecleaning in two other ways: (i) apply higher caps for MBS than treasuries, (ii) whenever either cap its exceeded, direct reinvestments solely to treasuries. I think at least one of these measures is likely.

4. Does

“clean” mean

shorter

duration

as well?

Reverse Operation Twist anyone? Before 2008, treasuries with a maturity of less than five years accounted for 80% of Fed assets. Half of total assets were set to mature within a year. Today, those metrics stand at 35% and 7%, respectively. It is not clear that the Fed wants to return to its short duration portfolio of yore. Yet, there are those at the central bank who think a “Reverse Twist” should be considered. Under a plan outlined in the latest minutes, it could reinvest any sum that exceeds the “caps” into shorter-duration treasuries. This would be a big change in policy as the Fed is now avoiding short-term treasuries and rolling over maturing treasuries into those notes and bonds that are on auction at the time.

A Reverse Twist is less likely than the Fed simply favouring treasuries as outlined in point #2. But if undertaken, it would have a bigger market impact. Long rates would be driven up, at least for companies. Long-dated treasuries may not follow suit if reduced demand from the Fed is offset by a move to safety. In this event, equity markets would suffer. For my base case, I assume that the Fed increases the caps gradually and maybe accelerates the shift from MBS to treasuries, but does not do a Reverse Twist. In this case, any rise in long rates is likely to be modest, but it would hardly come as a surprise to investors. This does not necessarily mean that US equities are free to push higher. However, return on invested capital is depressed, equity valuations are not attractive, and it is unclear that the private sector will pick up the slack in credit creation as the Fed contracts its balance sheet.

Unlike Anatole Kaltesky, I do think quantitative easing by the Fed has been a major driver of US and global asset prices since 2009. The relationship with equity prices really only broke down in November 2016, when hopes were raised that much-needed reforms to the US regulatory and tax codes may materialise. Hence, absent a pick-up in earnings and/or policy reforms, I suggest a conservative positioning — underweight equities and overweight US treasuries of mid- to shorter-duration.