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June 06, 2022

The Federal Reserve began the process Wednesday of shrinking its $8.9 trillion asset portfolio. Here are answers to five of the most commonly asked questions.

Q: When the Fed shrinks its asset portfolio, is it selling bonds?

No. The Fed dramatically expanded its portfolio in March 2020 to stabilize dysfunctional markets, and then it continued to purchase treasury and mortgage-backed securities in large quantities after that to provide additional stimulus to the economy by holding down longer-term yields. It ended those purchases in March 2022 and has been keeping its holdings steady since then by reinvesting the proceeds of maturing securities into new ones.

Starting June 1,the Fed will allow up to $30 billion in Treasurys and $17.5 billion in mortgage bonds to mature every month without investing the proceeds. The central bank is shrinking its holdings passively, or by attrition. (Because none of the Fed’s Treasury holdings mature until June 15, this process for Treasurys doesn’t actually take effect for one more week). In September, the Fed will allow twice as many securities—$60 billion in Treasurys and $35 billion in mortgage bonds—to run off its portfolio.

Q: But what about mortgage securities? Some Fed officials have said those could be actively sold at some point. Why is this under consideration?

The Fed has said that over the long run, it wants to own primarily Treasury securities. Selling mortgage assets would more quickly shift the composition of its asset holdings toward Treasurys.

The Fed didn’t actively sell mortgage bonds last decade, but it never ruled out such sales. And it hasn't ruled out sales of its $2.7 trillion in mortgage-backed securities at some point down the road this decade, because it will take a long time to shrink those holdings passively.

The 30-year mortgage rate has increased by more than 2 percentage points over the past six months, which will lead to much lower refinancing volumes and therefore fewer early paydowns of such long-term securities in the coming years. The upshot is that even though the Fed will allow up to $35 billion in mortgages to run off its portfolio by September, in most months, the Fed might see less than $20 billion in securities decline through passive runoff.

Officials haven’t decided whether or when to sell securities, and minutes from the Fed’s recent policy meetings haven’t provided many clues about the debate inside the central bank’s rate-setting committee.

Q: What does the Fed do with the money it receives from the payment of principal on its holdings?

The Fed essentially created money out of thin air to buy the bonds. Now, it will destroy the money in the same way.

When private investors buy bonds, they use cash, borrow funds or sell assets to raise the money to make that purchase. The Fed is different. It doesn’t have to do any of those things because it can electronically credit money to the accounts of bond dealers who sell mortgage-backed securities or Treasurys.

When the Fed purchases a security, it creates a bank deposit known as a reserve that shows up in the account of the seller. When the process is reversed, instead of reinvesting the proceeds of maturing bonds, the Fed erases them electronically. It doesn’t print currency to purchase the bonds, and so it won’t be destroying any paper currency. The electronic money essentially vanishes from the financial system.

Q: What effect does this have on the economy?

There is no consensus on the effects of the Fed’s asset purchases, sometimes called quantitative easing, and the portfolio runoff, sometimes called quantitative tightening. Several analysts have suggested that the runoff could be equivalent to one or two quarter-percentage point increases in its benchmark short-term interest rate.

Treasury debt issuance decisions also matter. In late 2018, some investors grew concerned about the effects of the Fed’s portfolio runoff, but back then, the amount of debt being issued by the Treasury was increasing sharply as tax revenues declined following tax cuts approved by then-President Donald Trump. Right now, tax revenues are surging, which could require the Treasury to issue less debt than would otherwise be the case. Please note that I have said this for years. Decrease taxes and you increase revenues…this is a case in point.  

Q: When will the Fed stop its portfolio runoff?

The end date isn’t clear. In 2019, the Fed slowed its runoff program much sooner than most officials had initially anticipated, and halted the runoff in July 2019, when the Fed cut interest rates amid concerns over an economic slowdown. In September 2019, turmoil in overnight lending markets led officials to conclude that they had drained too many reserves from the financial system, leading them to make a U-turn and increase the portfolio for several months. That fine-tuning was mooted by the aggressive response to the Covid-19 pandemic in March 2020.

In a February speech, Fed governor Christopher Waller said he thought reserves as a share of gross domestic product—around $3.8 trillion or 16% of GDP at the end of March—could potentially decline to levels seen in early 2019, when they were around 8% of GDP. Projections released last month by the New York Fed suggested that this might be consistent with allowing Treasury and mortgage holdings to decline to around $6 trillion in mid-2025.

The economy’s performance will also shape the endgame. The Fed could halt the runoff sooner if, for example, officials switch from raising rates to cutting rates in the next few years.

I am not a proponent of the Fed and their policies. I believe they experiment with theories only they can determine. Remember, they are not a Federal Government body. They are a banking entity. There is a mystery to how and why they do what they do. Their easing policies are a principal reason for inflation, and they then become the fall back to ease inflation. 

Even though I follow their policies, I find that following corporate numbers a more effective way of determining where the markets are headed. For now we follow the earnings reports for the second quarter in July.

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