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The Fed’s shrinking balance sheet: Three considerations for your investment strategy

By: Jeff Duesler, Senior Investment Services Representative

During the 2008 financial crisis, the Federal Open Market Committee (FOMC) began doing something unprecedented; they started quantitative easing (QE), an unconventional monetary policy, which consisted of buying government securities and other large-scale asset purchases from the market. The goal of QE programs was to boost the strength of the economy overall because QE lowers interest rates and increases the money supply to financial institutions, which is meant to promote more lending and liquidity.

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As a result, the Fed’s balance sheet currently sits around $4.5 trillion, significantly higher than the $858 billion prior to the beginning of the QE programs. In 2013, the FOMC announced that it would begin cutting back on QE, creating anxiety in the markets and causing investors to begin selling securities ahead of this. Recently, Fed Chair Janet Yellen announced (on September 20) that the FOMC would begin unwinding the balance sheet gradually and predictably. Let’s look at how this will unfold, what the impact might be, and three considerations for your investments strategy going forward.

The FOMC’s timeline for shrinking the balance sheet

The last thing the FOMC wants to do is disrupt any type of economic expansion if they don’t have to. This includes hindering the housing market recovery by causing a shock to long-term interest rates. Therefore, it is unlikely that this wind down will be anything different than advertised: gradual and predictable (as opposed to a fire sale or clearance liquidation).

Below is the FOMC’s timeline, at least for the near term:

  • Reduce Treasury securities each month in October, November, and December 2017 by $10 billion, then $6 billion thereafter.
  • Reduce mortgage-backed securities by no more than $4 billion each month, initially.
  • Increase the rate every quarter at which these securities are allowed to “run off” (mature) without reinvesting the proceeds until they hit $20 billion in mortgages and $30 billion in U.S. Treasuries.

The FOMC feels that following this schedule will allow them to speed up or slow down accordingly, while reaching the goal of normalizing the balance sheet and their policy stance. The “shrinking” will proceed until the balance sheet reaches an appropriate level for the banking industry’s demand for reserves (a lower level than the current 4.5 trillion and possibly a higher level than pre-financial crisis).

While not all market participants agree on the right way of shrinking the balance sheet, most can agree that it is both necessary and long overdue (the opinion of many). The main question is how will this ongoing balance-sheet reduction affect the markets and credit union investments?

Opinions on the economic impact: Will there be anything significant?

Both Yellen and the well-respected chief economic advisor for Allianz, Mohamed El-Erian, have referred to any “excitement” attached to the shrinking of the balance sheet as akin to watching paint dry. But others might beg to differ. For example, Goldman Sachs analysts predicted that the 10-year U.S. Treasury rates would rise about 20 basis points in 2017 because of the balance-sheet reduction. These same analysts also predict a 15 basis-point rise every subsequent year.

Other opinions are more tied to cause and effect. For example, if the employment markets and the economy truly benefited from the QE policies, wouldn’t the shrinking of the balance sheet be detrimental and reverse any benefits of the QE? The opposing argument would be that the QE gave the economy the shot in the arm it needed at the time, and the economy should continue to grow because the QE policies are no longer necessary and it’s time to move toward balance-sheet normalization, despite the shrinking balance sheet.

While it is too early to gauge the effect on labor markets and economic growth, the Goldman Sachs analysts were close in their prediction. On the day of the FOMC press conference on September 20, the 10-year note closed at 2.26%, while a month later, the 10-year treasury note is around 2.43%, which is very close to their initial 20 basis point prediction.

Is it possible that everyone is correct in this case? Certainly. You have two markets that are currently diverging with one another: equities and bonds. The announcement of the FOMC to shrink the balance sheet and the release of their plan on how it would happen certainly hasn’t spooked equity investors, and the bond market has finally seen some selling based on the expectation of higher rates and more appetite for risk.

Basically, we are all just going to have to wait and see what impact, if any, the shrinking balance sheet will have. It’s worth keeping an eye on that drying paint.

Your credit union’s current investing approach/portfolio construction: Should there be any changes?

No, there do not necessarily need to be any big changes made to your current strategy. I have stated on several occasions that it isn’t the timing of the market but your time in the market that’s more important. Are rates trending upward? Certainly. Will we see rates climb precipitously in the coming months, deeming anything that you purchase now a worthless investment? Not likely. In the meantime, perform a quick check-up on your investment portfolio. Below are three things to consider:

  • A laddered strategy should provide your credit union with enough liquidity every month. Is your credit union’s liquidity over-concentrated in any one month while a little thin in another month?
  • Select securities that are going to provide enough liquidity, maximize return, and minimize risk.
  • Consider adding some floating-rate securities to the portfolio to neutralize some interest rate risk and take advantage of the prospect for higher rates.

Keeping these considerations in mind, having a plan, and taking action will help you remain indifferent to what the Fed does, and it will be more enjoyable to watch everything unfold.