Will the mortgage rate usher the dawn under the shrinking balance sheet?
The Fed mentioned in its latest minutes that it will officially begin shrinking its balance sheet in May, and predicted it may be the largest ever. After the Federal Reserve started the interest rate hike cycle, the plan to shrink the balance sheet has also been put on the agenda. Some borrowers may feel strange about the sudden “shrinking of the balance sheet”. When the COVID-19 broke out in 2020, the Federal Reserve began to purchase large amounts of bonds from the market, with the aim to stimulate the economy by injecting money into the market. This process is known as QE (Quantitative Easing) policy. The most direct result of QE policy is a reduction in interest rates and an increase in market liquidity. Trough QE policy, the Fed’s ultimate goal is to lower the interest rate by adding currency to the market, thus achieving the purpose of stimulating the economy. In the past two years, the soaring stock market and housing prices, and the lower mortgage interest rate are all caused by QE policy.
Shrinking Balance Sheet can be seen as a reverse operation of QE policy, The direct purpose of it is to reduce the number of both sides of the balance sheet at the same time, so as to achieve the purpose of reducing the circulation of currency, which also brings an opposite effect of QE policy. The side effect of the QE policy is often inflation, and the current inflation is “high”, so after the Fed starts to raise interest rates, it has to fire up and start the Shrinking Balance Sheet, so as to “double-brake” the inflation.
In what way will this round of Shrinking Balance Sheet be carried out?
There are three main ways to reduce the size of bond purchases; to sell bonds directly; and to allow assets to be automatically redeemed at maturity (redemption), that is, to stop reinvestment at maturity.
All three methods can be used to reduce the size of the balance sheet, reduce the amount of money in circulation to raise interest rates, and control inflation.
The minutes of the latest monetary policy meeting released by the Federal Reserve show that in order to combat soaring inflation, policymakers “generally agreed” to reduce the Fed’s asset holdings by up to $95 billion per month.
The minutes also mentioned "primarily through reinvestment of principal received from SOMA's securities holdings," meaning that this round of shrinking will be "passive," rather than active selling, in the third way mentioned above. Many economists expect the Fed to aim to shrink its balance sheet by about $3 trillion over three years. But the minutes didn't detail how the cap would be phased in, a detail likely to be announced at the May meeting. If the Fed continues to shrink its balance sheet as projected, it will be the largest ever.
Shrink ing is accelerating , the impact may not intensified
The last round of shrinking was between 2017 and 2019. It took a very long time to start shrinking the balance sheet after four interest rate hikes in 2015. And it took all year for the Fed to reach its maximum rate of $50 billion a month.
This round of shrinking could go from zero to $95 billion in three months. Markets expect annual cuts of more than $1.1 trillion. This means that by the end of this year or early next year, the pace of contraction is expected to exceed the total for the entire 2017-2019 cycle.
Compared with the previous round, the Federal Reserve has reduced its balance sheet at a faster pace and with greater intensity, and sent a stronger tightening signal. Will an "aggressive" plan to shrink the balance sheet accelerate the rise in Treasury yields?
As mentioned above, this round of shrinking will be "passive" in the form of a halt to bond Reinvestment. However, "passive" shrinkage of the balance sheet does not form a market sell order, will not directly push up the long end of the interest rate, the impact on the interest rate is more indirect. Judging from the market reaction, the recent soaring market interest rates, including Treasury bond rates and mortgage rates, have already price-in the impact of subsequent interest rate hikes and balance-sheet shrinking, and almost choose the most "eagle" outcome.
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Post time: Apr-23-2022