Another Crisis Era Fed Policy Being Unwound

Last week the Federal Reserve released minutes from its March meeting, which provide the market additional insight into the committee’s thinking and outlook. Included in the minutes was a discussion of the balance sheet, which has expanded greatly since the financial crisis. The Fed’s bond purchasing programs, also known as quantitative easing, were designed to pull down interest and mortgage rates to help stimulate economic growth. In total, the size of the Fed’s balance sheet, comprised of U.S. Treasuries, agencies and government mortgages has grown to around $4.5 trillion, up from less than $1 trillion prior to the financial crisis. The current policy is to reinvest proceeds from interest payments and maturing securities into new securities, which keeps the size of the balance sheet steady. With the economy moving closer to the Fed’s targets, and the committee having recently raised the Fed Funds Rate, balance sheet normalization (reduction) is the most logical next step to bring monetary policy to a more normal state. Fed officials have been publically discussing the balance sheet in recent months, so the inclusion of this topic in the minutes was not unexpected. What will need to be ironed out in the coming months is how the Fed plans to implement the wind-down process. Fed officials do not currently appear to be united on how or when to begin this process, but we expect to have more clarity as we move through the year. 

The market impact of this news was muted, but as always, the ultimate impact will be driven by the details. Changing the bond buying program will leave a funding gap in the market, as a large marginal buyer (the Fed) will have to be replaced by others. This can impact interest rates as well as agency MBS rates and spreads. As can be seen in the chart below, this funding gap in 2018 will depend in large part on whether the Fed stops reinvesting completely, or simply slows down. Of particular importance to the overall economic outlook will be the knock-on effects of MBS market dynamics to the housing market, a significant driver of growth. We expect this story to become a larger one as we push through the year – stay tuned. 

Source: BMO Capital Markets, Wall Street Journal