The market recently got some much-needed insight into how much the Federal Reserve plans to shrink its balance sheet, which has ballooned to nearly $9 trillion in assets. This was largely due to the Fed's massive bond-buying program, which started at the beginning of the pandemic to ease the hard-hit economy.
In its recently disclosed March meeting minutes, the Fed said it plans to reduce its balance sheet by roughly $95 billion of assets per month later this year. That has the potential to cut its balance sheet by more than $1.1 trillion per year. Will markets continue to struggle when this massive effort begins?
Markets and the Fed's balance sheet
At the start of the pandemic, the Fed turned to quantitative easing (QE), which is the process of purchasing U.S. Treasury bills, mortgage-backed securities, and in some cases, other assets from the market. This has become a staple in its recession playbook.
The purpose of QE is to create an ultra-low-rate environment to support the economy with low borrowing costs and more liquidity. In QE, because the Fed is purchasing all of these bonds, it's reducing the supply in the open market, which drives bond prices up and yields down because bond prices and yields have an inverse relationship.
Source: Federal Reserve
The Fed started QE following the Great Recession and drove its balance sheet up to about $4.5 trillion of assets. It started to reduce its balance sheet in the years leading up to the pandemic. However, the surprise appearance of COVID-19 called for extreme and quick action, which led the Fed to nearly double its balance sheet to close to $9 trillion.
Now, however, with the job market strong and inflation surging, the Fed is moving quickly to raise its benchmark fed funds overnight lending rate and reduce its balance sheet. QE can inflate asset values, and the Fed will want to have this tool in its pocket for the next recession.
Image source: Getty Images.
For the Fed, shrinking its balance sheet, a process called quantitative tightening (QT), is not always so easy and can lead to chaos in the markets. The last time the Fed tried to shrink its balance sheet began at the end of 2017. But by 2019, the Fed decided to end its QT efforts after it apparently reduced it too quickly.
This led to an unexpected and rapid increase in U.S. overnight repo rates (chart below), which are short-term borrowing rates that allow investors to use U.S. Treasury Bills as collateral for cash needed in the short term. If it costs too much to borrow in the short term, it can create liquidity issues and disrupt markets.
Image source: Federal Reserve.
Will QT further harm markets?
It's hard to say exactly what impact QT will have on the markets. The Fed has essentially been warning the market of its intentions, which has led to a big sell-off. Because QE tends to provide more liquidity and be supportive of the stock market, it's only natural that QT does the opposite.
The Fed will try to engineer a soft landing and achieve its monetary goals without too much disruption. It also believes it's better prepared this time around to deal with liquidity issues.
But this is a massive undertaking, and the reduction of the Fed's balance sheet and most of the benchmark market indexes such as the Dow Jones Industrial Index, S&P 500, and Nasdaq Composite are still well above where they were pre-pandemic. On the other hand, at its planned pace of a $95 billion asset reduction per month, the Fed will still need a good four or five years to return its balance sheet to pre-pandemic levels.
During that time, a lot of things could disrupt the Fed's plans or speed them up. Investors will want to be cognizant of QT as they invest and be careful about investing in companies with inflated valuations because these can take a hit as the Fed removes liquidity from the markets.
