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Will interest rates rise sharply as the Fed shrinks its balance sheet?

I usually reserve Friday blog posts for lighter topics but with the FOMC meeting this week, I think it is important to touch on the Fed's plan to shrink its $4.5 trillion balance sheet. While the announcement was widely expected, it spelled out in greater detail plans to slowly unwind the Fed's sizable bond holdings. We believe that this step is very positive alongside interest rate hikes. The economy is doing well enough that the Fed can step back from its emergency measures, thus saving ammo for the next recession. We do not believe that this will cause a spike in long term rates but will monitor the situation closely.

Since the Great Recession, the Fed has provided the market with huge liquidity through asset purchase programs. The Fed stopped adding to its holdings in 2014 but has continued to reinvest the proceeds of maturing assets to maintain the portfolio's size.

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Fed Chair Janet Yellen announced the start of reducing the Central Bank's holdings gradually by allowing a small amount of net maturities every month. This process will likely begin in September or October, and the Fed will allow up to $6 billion in Treasury securities and $4 billion in mortgage bonds to roll off without reinvestment. These amounts will rise each quarter with the goal of having a maximum of $30 billion a month for Treasurys and $20 billion a month for mortgage-backed securities.

Markets should be unfazed by this change

Removing the Fed as a buyer of bonds is causing some concern on Wall Street that long-term rates could rise quicker than anticipated. However, the 30-year Treasury yield has actually headed lower this year despite the Fed signaling that it intends to shrink its bond holdings. On March 13th, 30-year yields were at 3.21% and on Wednesday at 2.77%.

According to FTN Financial, the Fed has been buying around $24 billion in mortgage securities a month this year and around $17.5 billion in Treasuries. To put this into context, it is a very small portion of US Treasury average daily volume. According to SIFMA, over $500 billion of Treasuries are traded per day. So even when the Fed gets to its goal of allowing $30 billion of Treasuries to roll off their balance sheet per month, that amounts to just 0.3% of the monthly trading volume. That's pretty insignificant so we don't expect a spike in rates resulting from the Fed's actions. Furthermore, if we see an increased volatility in rates, the Fed would likely step back from the situation and reassess their plans.

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About the Author: Chris Wang

Chris Wang

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