As part of its June communications, the Federal Reserve announced that it was planning to reduce its balance sheet holdings of mortgage-backed securities and U.S. Treasuries.1 Our view is that these assets maturing will have virtually no effect on financial markets.
As a reminder, the Fed now holds $2 trillion in mortgage-backed securities (MBS) and $2.5 trillion in mostly long-dated U.S. Treasuries as a result of its post-financial crisis “unconventional” policy efforts to stabilize financial markets. The Fed started backing away from these policies when it began tapering — that is, when it moved away from wholesale asset purchases and only reinvested proceeds from its current portfolio as securities became due. These actions stabilized the Fed balance sheet.
Now, under the current policy directive, the Fed intends to reduce its balance sheet by small amounts, very small amounts as it turns out, by allowing securities to mature rather than reinvesting the proceeds to achieve a steady but moderate balance sheet runoff. In her June 14 press conference, Chair Janet Yellen indicated that the intention is to establish caps on the rate of decline in the Fed’s balance sheet that start at $10 billion a month ($6 billion for Treasuries and $4 billion for MBS) and increase to $50 billion monthly over the course of a year.2
Financial mavens identify the Fed’s policy shift as a stock market risk. We believe that the stock market is risky for other reasons. These reasons include cyclically weak corporate profitability or possibly pro-cyclical dynamics from new market instruments like exchange-traded funds, but not Federal Reserve asset sales.
Why? First, the impact of the Fed’s supply to private markets is imperceptible given the size of the Treasury and MBS markets. Total marketable Treasuries outstanding exceed $14 trillion, of which bonds — Treasury securities with 20- and 30-year maturities — total $2 trillion. The total mortgage-backed security market is about $8 trillion (Chart 1).
It is important to note that to the extent proceeds from maturing securities exceed the caps and are reinvested, the Fed remains an important source of demand in the MBS market. Under this plan, the decline in the Fed’s balance sheet could reach a maximum of $50 billion (i.e., the cap on the balance sheet decline) a month one year out in a combined market of about $10 trillion. Detailed projections of the Fed’s balance sheet draw down can be found here.
Second, the Fed’s holdings of MBS are a small share of the MBS market. Of the total $8 trillion MBS market, the Fed holds less than $2 trillion (Chart 2). Whether looking at either the Treasury or the MBS markets, the Fed’s runoff, which could be as high as $50 billion a month under current caps, is a drop in the proverbial bucket.
Third, and most compelling, is the fact that MBS and Treasury bonds have each generated about a 50 percent total return for investors since the crisis (Chart 3). Given the implied credit risk in MBS and the rock-bottom current yields in Treasury bonds, rising prices have provided the lion’s share of the returns.
Rising prices suggests that demand is greater than supply. Small increases in supply should not disturb this inherent market imbalance. As Chart 1 shows, the supply of Treasury bonds more than tripled in the post-crisis years and still Treasury bond prices went up, while bond yields went down and/or stayed low.
2 Exact quote: “For both Treasury and agency securities, we will reinvest proceeds from our holdings only to the extent that they exceed gradually rising caps on the reductions in our securities holdings. Initially, these caps will be set at relatively low levels—$6 billion per month for Treasuries and $4 billion per month for agencies. So, any proceeds exceeding those amounts would be reinvested. These caps will gradually rise over the course of a year to maximums of $30 billion per month for Treasuries and $20 billion per month for agency securities and will remain in place through the normalization process.”
Login in below to access content exclusive to clients of The GailFosler Group.
Not a client yet? For more information on the benefits of becoming a client, please contact us.