Shrinkage And Beyond

After much anticipation, the FOMC decision day is here. Much of the focus is on the likely decision that the Fed will allow its balance sheet to shrink gradually. No other country who employed quantitative easing has is in a position to begin unwinding the emergency expansion of its balance sheet.  The Fed’s experience in QE, communication, and now unwinding, will be part of the information set other central banks can draw upon. 

Initially, the idea of unwinding the central bank’s balance sheet seemed to entail the sales of securities. However, the FOMC’s strategy is not to sell a single security, but simply slow the reinvesting of the maturing issues. We suspect this is likely to be the main path for other central banks, eventually, as well. The reinvestment of maturing securities was roughly equivalent to 40% of the deficit last year.  

Many worry that if the Fed is absorbing the supply, the market will, and the key is the price that is does this. However, much of the thinking seems confused because many insist that interest rates are low because the central banks have been buying bonds. The story is more complicated. Remember, US yields typically rose while QE was active and fell when the buying ceased. We argue that the real reason rates are low is that growth and inflation are low, and that the supply of capital exceeds its effective demand.

The impact of the gradual unwinding of the Fed’s balance sheet is not known. Many, like us, expect the very low starting point ($10 bln a month for the first three months), is unlikely to be disruptive. The signaling impact has also been modest. Surveys have shown that majority have expected that today’s meeting would be the forum for the policy announcement. It did not prevent the 10-year yield from falling to new lows of the year a couple weeks ago.  

Another way to say this is that there is a myriad for factors that drive US interest rates. Fed actions are important but there are other factors that could overwhelm. For example, this year, as China’s reserves have begun growing this year after falling. As China’s reserves grow, its demand for Treasuries has grown. According to US data, and not doing what seems to be the popular thing, attributing other financial center’s holdings of Treasuries to China, China’s holdings of Treasuries have risen by $108 bln through the first seven months of the year.