The protocol showed that, after retreating from near the zero-interest rate, the FED decided to take another tool to influence the economy – a balance sheet. Most members of the committee spoke in favour of reducing the balance later in 2017, supporting the idea of a gradual rate increase. Let’s try to understand which are the consequences of changes in the asset-purchase program and how it could impact the rate hike path.
Since 2007, the FED’s balance sheet has grown rapidly from $900 billion to $4.5 trillion, as a result preventing bankruptcies of the countries key financial institutions and combating volatility. It consists primarily of the treasury bonds and mortgage-backed securities. In 2014, after announcing the discontinuation of asset purchases, the FED uses a reinvestment policy, using the bond principal to keep purchasing from the market, and maintaining the balance on a constant level. The central bank also receives interest, which is used to pay for deposits made by financial institutions.
One of the reasons for cutting the balance sheet are the falling yields of the securities, as a result, the increase in the borrowing rate. The balance sheet income compensates for the payments to the fund holding institutions in the central bank, in the case of low rates. Yet, if there is an increase in the rates then that leads to an expanse in the interest payments and securities yields of the balance sheet shrink.
To start the process, FED has three options – stopping the reinvestment immediately, (clearly informing the market of its intentions), reducing purchases gradually, (avoiding volatility that will leave room for uncertainty), or starting to sell the assets. If they decide on ceasing the reinvestment, then the balance will be reduced due to bonds that have reached maturity (mainly treasury securities, since most mortgage-backed securities have maturities after 2040).
None of these options promises anything positive for the fixed income market. Retreating from the post of the main investor, the FED will shift the burden to the market, which can cause a sharp rise in supply, and hence demand higher yields (since investors will prefer securities with higher yields). In turn, the regulator will be forced to exercise caution in the raised rates, which was announced yesterday in the FOMC protocol.
The US stock market closed in the red zone, as the FED’s unwillingness to act further as a “safety cushion” increased the degree of caution among investors. The US currency demonstrates robustness after a strong ADP employment report, expecting that NFP data will also be higher than expected.