The Federal Reserve's plans to shrink its massive balance sheet will likely reduce the risk of government bond yields inverting, one sign of an impending recession, and lessen the need for some future interest-rate hikes.
The rate-setting Federal Open Market Committee agreed during its March meeting that the central bank’s $9 trillion balance sheet needs to be reduced, according to minutes released earlier in April. Under a plan to shed $95 billion in assets per month starting in May, the Fed would reduce its balance sheet by more than $1.1 trillion per year.
The reduction will help avoid sustained inversion of the Treasury yield curve, where shorter tenure bond yields, such as the 2- and 5-year yields, climb above longer-dated yields, such as the 10- and 30-year bonds, as they did in the first few days of April. The Fed's balance sheet moves could also reduce its appetite for some future rate hikes.
"Ultimately, shrinking the balance sheet is about reducing liquidity to the financial system along with raising the cost of capital," said Kathy Jones, managing director and chief fixed-income strategist with the Schwab Center for Financial Research. "In that way, it's similar to hiking rates."
Fed yield impact
The Fed's balance sheet has more than doubled since the Fed began buying $120 billion per month in Treasurys and mortgage-backed securities early in the pandemic. The balance sheet's record-breaking size has put "significant downward pressure" on longer-run interest rates and distorted markets, said Esther George, president of the Federal Reserve Bank of Kansas City, in a March 30 speech.
The Fed owns roughly 25% of the total mortgage-backed securities market, George said, while central bank data shows it is holding about $5.8 trillion in Treasurys.
"While many factors influence longer-term yields, including the growth outlook, foreign demand for Treasuries, and the quantity and maturity of Treasury debt issuance, the Fed's asset holdings also play a role," George said. "Our presence in financial markets muddies price signals, encourages excessive risk-taking, and can foster financial instability."
The Fed's securities purchases have depressed longer-term rates, causing some portions of the Treasury yield curve to briefly invert, one sign that a recession could be near. The Fed's balance sheet reduction will likely put upward pressure on those rates, potentially steepening the yield curve, as longer-dated yields outpace shorter-term yields, George said.
Since George's March 30 speech, longer-term Treasury yields, which move opposite bond prices, have surged.
The yield of the U.S. Treasury 10-year bond closed April 11 at 2.79%, up 44 basis points since March 30 and its highest yield in roughly three years. The yield on the 20-year bond was up 39 bps from March 30 to April 11, while the 30-year yield jumped 36 bps over that time.
The recent jump in longer-term rates seemed to have reversed an inversion of some portions of the Treasury yield curve.
While curve inversion has preceded every recession over the past 50 years, steepening the curve is not the Fed's priority in reduction of the balance sheet, said Gregory Daco, chief economist for EY-Parthenon.
"Their main intent is to regain control of inflation," said Daco.
Still, a flat curve — where interest rates for shorter tenure bonds are closer to longer-dated yields — or a steeper one could be a byproduct of balance sheet reduction, as could fewer future rate hikes.
Rate hike reduction
Depending on how quick the balance sheet reduction is, it may shave up to 75 bps off the Fed's trajectory for rates over the next two years, Jones with Schwab said.
The futures market expects the Fed to hike rates at every remaining FOMC meeting this year, with a majority predicting the central bank raising the target rate by as much as 225 to 250 bps, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.
As of April 11, roughly 84% of the market expected the Fed to hike by 50 bps at its May meeting. That is double the Fed's more traditional 25 bps hike.
Fed officials are also expected to begin reducing the balance sheet at that May meeting, which could ultimately influence its future path on rate hikes.
"The Fed definitely considers the balance sheet when thinking about future rate hikes," said Callie Cox, an investment analyst with eToro. "Balance sheet runoff is another tool in their toolbox."
Trimming the balance sheet by roughly $1 trillion per year will allow the Fed to tighten monetary policy by doing more than just rate hikes, said Gennadiy Goldberg, a senior rates strategist with TD Securities.
This will decrease the need for the Fed to "overshoot" on rates, which could unnecessarily slow the economy, Goldberg said.