Get Ready for Fed Balance Sheet Normalization
When the Federal Reserve began amassing Treasuries and mortgage-backed securities to fight deflation in the wake of the 2008 financial crisis, no one knew for sure how much debt it would add to the nation’s balance sheet, or how long the unprecedented “quantitative easing” program would last. While the answers are still by no means set in stone, this month’s research report, Fed Balance Sheet Normalization, provides insight into when the Fed will start drawing down the balance, how long it may take, and what impact the unwinding may have on institutional cash investors.
Starting with a balance of $925 billion in September 2008 just prior to the Lehman Brothers bankruptcy, the Fed’s massive asset accumulation peaked at just over $4.5 trillion in January 2015. Since then it has maintained a relatively stable balance, hovering at just under $4.5 trillion as of May 31, 2017. But if there’s one law of finance that every cash investor can count on, it’s “what goes up must come down.” The Fed has started to signal it will start to reduce its balance sheet, possibly as early as the end of 2017, in what many observers indicate may be a two-to-three-year winding down of the quantitative easing program.
Corporate cash managers are well advised to start planning now for the market impact of the reversal. Among other things, cash investors can watch for higher interest rates in Treasury securities, higher short-term rates, greater demand for T-bills, less Fed capacity for reverse-repos, and steeper yield curves. Any of these market outcomes may have a material impact on the liquidity, risk and return in corporate cash portfolios.