I am writing this short article because I saw a post recently on Twitter saying that the Federal Reserve’s balance sheet had grown this year and therefore the Fed had not started its programme of balance sheet reduction (i.e. quantitative tightening or “QT”). Whilst the first part of this statement is true, the second part is not. This inspired me to take a quick look at the Federal Reserve’s balance sheet, and to also look at a few other things that are important as you are thinking about the effects in the financial markets of the Fed transitioning from a buyer of US Treasuries and MBS to a seller. Did you know that:
The Federal Reserve’s balance sheet, at just under $9 trillion, is 39% of the 2021 GDP of the US (around $23 trillion). The amount of central bank assets as a percentage of GDP is higher in Japan (110% of GDP) and the Eurozone (70% of GDP) [1], but is slightly lower in the UK (36%).
The Federal Reserve’s balance sheet was less than $1 trillion before the GFC. The balance sheet increased ninefold to nearly $9 trillion by April 2022. The dramatic increase over the last 14 years is attributable to multiple rounds of QE during and following the GFC (pre-pandemic peak of $4.5 trillion in Dec 2014). Having been reduced by around $700 bln late in the last decade, the Fed’s balance sheet then rocketed up again during the pandemic, doubling to nearly $9 trillion at its peak a few months ago.
The US Treasury secondary market (bills, notes and bonds) is $23.3 trillion (source: SIFMA), of which the Federal Reserve holds approximately one-quarter ($5.76 trillion), and
The agency mortgage-backed securities (“MBS”) secondary market is $10.7 trillion (source SIFMA), of which the Federal Reserve also holds approximately one quarter ($2.72 trillion).
Size and trend of the Federal Reserve’s balance sheet
During the current year, the trend in total assets of the Federal Reserve’s balance sheet is depicted in the graph below from FRED.
As you can see, the balance sheet of the Fed was around $8.76 trillion at the beginning of the year, peaked at $8.96 trillion in early April, and has since declined to $8.85 trillion as of last week. So it is true that the Fed’s balance sheet is larger than at the beginning of the year, but it has been declining since the beginning of the summer and will continue to do so.
The plan for balance sheet reduction (“quantitative tightening”)
The Fed provided its roadmap to reducing its balance sheet on May 4th following an FOMC meeting. The Fed announced that it would not roll over maturing USTs and MBS in the following amounts starting in June:
$47.5 bn /month for three months starting in June, comprised of $30 bn UST and $17.5 bln MBS, and
Doubling the amount to $95 bln / month starting in September, comprised of $60 bln of UST and $35 bln of MBS.
The May 4th press release from the Federal Reserve describing the QT programme is here. The ongoing reduction in the balance sheet is open-ended, and I suspect the Fed will continue these monthly reductions as long as it can without causing significant disruption in the UST and MBS markets, which could spill over easily into the corporate bond market.
Maturity profile of the Federal Reserve’s balance sheet
The Federal Reserve files a form H.4.1 every Thursday, which provides detail on its balance sheet. On the H.F.1 form filed this past Thursday (August 18th, here), the Fed’s balance sheet was $8.837 trillion, comprised principally of US Treasury securities ($5.76 trillion) and agency mortgage-backed securities ($2.715 trillion). The Federal Reserve Bank of St Louis provides a detailed maturity breakdown of the two major asset categories of the Federal Reserve: “Table 2. Maturity Distribution of Securities, Loans, and Selected Other Assets and Liabilities”. I have summarised the maturity profile in the table below:
As you can see in the table, at a run-rate of $95 bln/month, consisting of $60 bln/month of US Treasuries and $35 bln/month of MBS, there is easily capacity for the Fed to simply not roll-over a portion of maturing USTs (in that $1.2 trillion are due in the next year). In the MBS market, the maturity profile of these issues is extremely long with very little principal contractually due before 10-years. However, one of the nuances of MBS is that the securities involve pass-through structures, meaning that there are cash flows each month consisting of interest and principal from a large underlying pool of 15- and 30-year mortgages. Although there is no contractual principal payment due per se until maturity on MBS, cash flows occur each month that consist of both interest payments and non-contractual principal payments. I suspect there is more than ample principal repayments coming in each month to meet the $35bln/month in reduction in MBS pursuant to the Fed’s QT programme.
Putting the Federal Reserve’s holdings of UST and MBS in context
In 2021, the US government issued $19.5 trillion (gross) in US Treasury securities across all maturities, including bills, notes and bonds, according to SIFMA (see download link on SIMFA website here). YtD in 2022 (through July), total issuance (gross) has been $9.4 trillion. To provide some context, in the 10 years 2010-2019 (pre-pandemic), UST issuance averaged $8.5 trillion/year, although it did increase the last two years of the decade. The pandemic led to substantial additional borrowing by the US government in the Treasury market: $21 trillion (gross) of USTs were issued in 2020, net $1.5 trillion; and $19.5 trillion (gross) of USTs were issued in 2021, net $667 bln. As you can see though, the proceeds of most new USTs are simply used to refinance (or rollover) existing UST debt.
From the end of 2019 (per-pandemic) to the end of 2021, the Federal Reserve’s holdings of US Treasuries increased $3.5 trillion, meaning that the Federal Reserve provided a bid for around 8.6% of all gross new UST issuance, underpinning yields on US Treasuries.
As far as MBS, there were $8.2 trillion of gross new issuance in 2020 and 2021 collectively. MBS held by the Federal Reserve increased $1.2 trillion over the same period, accounting again for a meaningful bid on new MBS issuance and underpinning yields in this market.
The question will now becomes the direction of travel of yields since the Federal Reserve has turned from a buyer of UST and (effectively) a seller. So far, fears of a pending recession have anchored intermediate and long-term yields at levels not dis-similar to where they were before the Fed announced its QT programme on May 4th. The yield on the 10y UST ended that day at 2.93%. On Friday (August 19th), the yield on the 10y UST ended the day at 2.98%, only 5bps wider. It is true though that there was considerable variation during this relatively short period – the yield on the 10y UST ranged from 2.60% to 3.49%.
We started this period with the inflation narrative dominating investor sentiment, but now, it is a fear of a sharp economic slowdown or even a recession that is dominating investors’ thoughts. This shifting sentiment has provided support for intermediate and longer-maturity government bonds, but the inflation narrative and the Fed’s ongoing quest to rein in inflation has played havoc with shorter maturities. Whilst the yield on the 10y UST has barely moved since May 4th (end-to-end), the yield on the 2y UST increased from 2.66% on May 4th to 3.25% on Friday. As you can see, this means the yield curve has also inverted, with the 2-10y yield curve becoming negative in early July and remaining inverted since then. The 2-10y yield difference was negative 27bps at Friday’s close. If you are wondering why there is so much discussion about a possible recession, take a look at the graph below from FRED.
As you can see, every recession since the mid 1970s has been preceded by a yield curve inversion, more pronounced before the Federal Reserve introduced its unconventional monetary policies during the GFC. Without question, this manipulation could easily result in false signs, but eventually one way or the other, these will work their way through markets.
Conclusion
I hope that this short article about the Federal Reserve has provided you with some interesting context and ideally some thoughts as you look ahead at a market in which traditional asset prices are being pulled in both directions. The combination of a stronger economic outlook and the Fed becoming a seller will likely push intermediate and longer-term UST yields higher at some point. However, we are currently looking at a weakening US economy, not an improving one, which will undoubtedly be exacerbated by the gradual increase in the Fed Funds rate. There is no way out of this for the Fed because it has to focus almost exclusively at the moment on containing inflation. The questions the Fed have to consider are how high unemployment will need to go and how much will growth have to slow before the Fed eases off the accelerator. At that point, we will see the yield curve right itself and then re-steepen as growth moves back to the forefront. When this might happen though is anyone’s guess.
[1] This is based on GDP of the Eurozone in 2021 of $14.493 trillion (at average exchange rate of €0.8458/US$1.00), or €12.258 trillion, and ECB debt at Y/E 2021 of €8.56 trillion. This is consolidated Eurosystem debt, which I assume is equivalent to the amount of consolidated debt at the Federal Reserve.
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