Posted by lplresearch
Tuesday, February 8, 2022
Since the beginning of the COVID-19 pandemic, the Federal Reserve (Fed) has been supporting financial markets by buying $120 billion of U.S. Treasury and mortgage-backed securities (MBS) each month. Currently, the Fed is in the process of reducing (tapering) the amount of asset purchases but is still adding to its balance sheet. However, meeting minutes from the December 2021 Fed policy meeting indicated that the Fed may begin to reduce the size of its balance sheet in 2022. Balance sheet runoff, or quantitative tightening (QT) as it’s also called, is how the Fed plans to reduce the size of its balance sheet. Currently, as bonds mature, the Fed reinvests those proceeds back into Treasury or mortgage securities. However, the Fed plans to forgo reinvestment and allow the bonds to mature and not replace them. While the Fed has not made a decision on when QT would begin, it is largely expected that runoff would likely begin in the second half of 2022.
“Fed balance sheet runoff is something we’re likely to hear a lot about over the next few months,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “It’s only happened one other time and the Fed didn’t get too far before having to reverse course. But with one episode under its belt and additional tools at its disposal, we think this time will go more smoothly.”
As seen in the LPL Chart of the Day, the Fed’s balance sheet has ballooned to nearly 40% of U.S. GDP recently from under 20% pre-pandemic. Fed Chair Jerome Powell has stated that the Committee would like to get the balance sheet back to around 20% of GDP. As such, the Fed would need to reduce its balance sheet by several trillion dollars over the next few years to get back to that 20% level. So should fixed income investors be concerned?
We only have one recent data point we can leverage- the Fed reduced the size of its balance sheet from 2018 to 2019. The Fed announced intentions to reduce its balance sheet in June of 2017, with the reduction taking place from January 2018 through September of 2019. In March 2019, the Fed announced this runoff would conclude in September of that year. The table below examines how broad fixed income sectors performed immediately after Fed’s intentions were announced, during the full balance sheet runoff period, and after the Fed informed market participants that this runoff would end. With less monetary accommodation, one would assume that fixed income returns would be negative. However, as the table indicates, these indices produced strong positive returns during all periods. The Fed’s exit as a buyer of Treasuries and MBS did not result in negative performance for these sectors during the previous episode.
While many market factors are at play, based on the 2018-2019 Fed balance sheet runoff period, fixed income returns may not be that negatively impacted by the looming balance sheet runoff. However, there is still considerable uncertainty on how balance sheet runoff will be structured and implemented. Best case scenario is that balance sheet runoff commences in the background with little impact on markets (with interest rate hikes still being the primary tool for reducing monetary support). Unfortunately, Fed balance sheet decisions are likely to add to market volatility over the next few years.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
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All index and market data from FactSet and MarketWatch.
This Research material was prepared by LPL Financial, LLC.
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