“Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017-19.” Fed Governor Lael Brainard.
This was the quote that changed interest rates in a “New York Minute.” Why? Governor Brainard expects to shrink the balance sheet larger and faster than they did back in 2018.
Balance sheet reduction/Quantitative Tightening (QT) explained:
The Federal Reserve has nearly $9T worth of Treasuries and Mortgage-backed securities (MBS) on its balance sheet, with an outsized portion coming in the last two years as the Fed purchased $120B of bonds per month for most of 2020 and all of 2021 in a process called Quantitative Easing (QE).
QT is the opposite of QE and a process where the Fed removes bonds off its balance sheet. MBS, where home loan rates are derived, can be paid off either through refinance or purchase activity or from maturation. When the Fed receives this principle, they have been using those proceeds to purchase more MBS. That will no longer happen.
In QT, the Fed will set a cap that will increase every month and ultimately get to $35B. The Fed will take the principal up to $35B and give it back to the Treasury Department. Any principal received in a month above $35B would be reinvested back into MBS.
The idea that the Fed would go from buying bonds to “rapidly” removing them from their balance sheet spooked the financial markets. History tells us the financial markets may be over-reacting to the idea the Fed is going to shrink its balance sheet (QT) and push rates much higher. Back in 2018 the Fed shrunk its balance sheet modestly and rates did move higher, but by the time the Fed stopped in mid-2019, home loan rates were lower than when they began.
Much like in 2018, we should expect any balance sheet reduction to be gradual with the Fed quickly adjusting based on incoming economic data much as they did back in 2019.
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