The Federal Reserve raised interest rates a quarter of a percent in December taking the target range for the federal funds rate to 2.25 to 2.50%. Last week, the Federal Reserve indicated that the Fed funds rate is now near “neutral” and that the target interest rate is unlikely to move unless the economy reaccelerates or deteriorates significantly from here.
Historically the federal funds rate has been a major focus of market participants. When interest rates hit zero during the Great Recession, the Federal Reserve decided it would not take rates below zero. Instead, it unleashed quantitative easing to loosen monetary policy. In a nutshell, this means buying debt on the open market and holding it on their balance sheet. Once the economy appeared to be on firmer footing, this was followed by quantitative tightening or in other words, moving the debt off their balance sheet and back into the markets. This continues at a maximum of fifty billion dollars per month dependent on market conditions. There are now indications that the Federal Reserve is considering ending quantitative tightening later in the year. This is supported by most of the members of the Federal Open Market Committee.
It is not known what will happen to the composition of the balance sheet once the Federal Reserve reaches its target level which is at this point yet to be determined or publicly disclosed. Currently the balance sheet has US Treasuries of varying maturities and mortgage backed securities. Speculation from informed Federal Reserve watchers indicates a high likelihood that the Federal Reserve will stop reinvesting in mortgage-backed securities or reduce the reinvestment in these bonds. A shift from mortgage-backed securities to Treasuries will have several implications for financial markets. Repayments of mortgage-backed securities are inherently uncertain. Lower rates usually result in quicker repayments as homeowners refinance, while higher rates see homeowners paying only the minimum required monthly payments. The prepayment and extension risk will be removed from the Fed’s balance sheet as these bonds mature.
It also bears watching how the Federal Reserve reinvests in Treasuries. It is currently purchasing a proportionate percentage of new issues. Historically, the Federal Reserve held only Treasury Bills. If the Federal Reserve returns to only buying T-Bills or shorter-term securities, it would see the duration of its balance sheet reduce measurably and move risk back to the private sector. This would also put pressure on the yield curve to steepen which would reduce the risk of a yield curve inversion and be positive for bank margins.
A targeted run-off of mortgage-backed securities and/or a reduction in the duration of the Federal Reserve’s Treasury holdings could be viewed as a reversal of Operation Twist which saw the Fed buy longer-term Treasuries with the goal of promoting investment and risk-taking. A reversion to historical balance sheet composition may be a continuation of Federal Reserve tightening, but is likely to have less drastic effects on markets and economies than many analysts believe quantitative tightening has. The bottom line is, should the Fed return to a normalized balance sheet, there would still be a tightening bias. This is all new territory and bears close watching as the Fed navigates these waters and we see how financial markets react.