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Fed's Balance Sheet: Mind the Gaps

The Fed is on a trajectory to enter the next phase of normalizing policy as early as this fall. This involves reducing their balance sheet by paring back holdings of Treasuries and MBS. The Fed is deeply immersed in both markets and receding from them could trigger a sharp response in depressed rates and volatility.

For their part, markets are quite sanguine about the impact balance sheet reduction may have on interest rates and bond volatility. This is because they have been conditioned over the last two years to be skeptical of the Fed’s bold policy paths. Markets simply don’t believe the Fed has the gumption to push forward with this next phase.

In our view, markets are overlooking both the Fed’s resolve to normalize policy and the impact their receding from bond markets will have. There are at least three reasons to think the Fed reducing their bond holdings will have a meaningful impact on long term rates:

1.)FOMC’s “credibility gap” makes a sharp adjustment in policy expectations more likely: The longer it takes for market expectations to converge with the Fed’s policy trajectory, the greater the potential for an abrupt price move.
2.)Looming” demand gap” once the Fed begins to recede from bond markets: As Fed purchases decrease, there are no natural sources of demand to fill the gap and it seems likely interest rates will have to increase.
3.)Tightly compressed term premia are like a coiled spring ready to snap back: Term premia are likely to widen sharply even if the Fed proceeds at a very “gradual and predictable” pace.