The Federal Open Market Committee (FOMC) continued to tighten monetary policy last week with the unwinding of its balance sheet. The Fed balance sheet was marked at $3.969 trillion on March 6, down $5 billion from $3.974 trillion on Feb. 27, which is a modest Fed tightening move. The balance sheet is down $531 billion from its level of $4.5 trillion at the end of September 2017.
In my opinion, the Fed wants to continue to unwind the balance sheet until later this year. I believe that that the Fed is aggressive now given stable stock market conditions. The normalization of Federal Reserve policy includes the unwinding of its bloated balance sheet.
The Federal Reserve balance sheet was expanded by policies called quantitative easing (QE). Under QE, the Federal Reserve bought U.S. Treasuries and Federal Agency Securities. These buying programs took place between December 2008 and October 2014. The Fed purchased $3.7 trillion in securities, which expanded the balance sheet to $4.5 trillion. The purpose of QE was to pump money into the banking system to support economic growth by driving down longer-term interest rates.
The Yield on the 30-Year U.S. Treasury Bond
The weekly chart for the 30-Year U.S. Treasury Bond yield shows that, during QE, the yield declined from a high of 4.85% set in April 2010 to a low of 2.09% in July 2016. Even when the QE purchases ended, the policy was to reinvest proceeds of maturing issues, keeping the balance sheet at $4.5 trillion.
It was around this time that the Federal Reserve announced its intention to unwind the balance sheet, marking the cycle low for yields. This unwinding began in October 2017. The process began at just $10 billion per month in Q4 2017. In Q1 2018, it jumped to $20 billion per month. In Q2, it jumped to $30 billion per month. In Q3 2018, the pace was $40 billion per month. When the pace rose to its maximum of $50 billion per month in October 2018, the stock began its bear market decline. At that time, the balance sheet stood at $4.193 trillion for a drain of $307 billion.
The stock market decline prompted the Federal Reserve to stop raising the federal funds rate and to ease back on the balance sheet unwinding. The FOMC raised the federal funds rate to 2.25% to 2.50% on Dec. 19, 2018, where it will likely stay for all of 2019.
The unwinding of the balance sheet occurs primarily by letting securities mature and not reinvesting the proceeds. I believed that unwinding would last through 2020, but now, given economic and stock market uncertainty, the Federal Reserve may stall at the end of 2019.
Looking back at the weekly chart for the 30-Year Treasury yield, note how the 200-week simple moving average (in green) is the "reversion to the mean" as yields fall, then rise. The rise in yield above the 200-week simple moving average began as 2018 began, and the high yield of 3.46% occurred in November as the monthly unwinding was on a schedule of $50 billion per month. This yield fell back to its 200-week simple moving average at 2.88% as stocks declined and 2019 began. With stocks falling, the Fed unwinding dropped to $30 billion in January, but the pace has picked back up to $50 billion in February.
In conclusion, the Federal Reserve will continue to tighten monetary policy by unwinding its balance sheet through the end of 2019 unless there are economic and market dislocations. The federal funds rate will stay at 2.25% to 2.50% as the high end of the Fed's neutral zone of normalization.
Graph of the Fed Balance Sheet
At the close each Wednesday, the Federal Reserve takes a snapshot of its balance sheet, and the results are updated after 4:00 p.m. on Thursday. Sometimes, this graph is not updated until Friday or Saturday. Wall Street does not focus on this as an economic release, but I actively follow it as an important market-sensitive indicator.
Disclosure: The author has no positions in any securities mentioned and no plans to initiate any positions within the next 72 hours.