Why the Fed won't 'rock the boat' with its balance sheet

The Federal Reserve has been reducing its balance sheet, although it still remains above pre-pandemic levels.

BlackRock Senior Portfolio Manager on the Global Tactical Asset Allocation team Tom Becker joins Catalysts to give insight into the Fed's balance sheet and how what the central bank does it with it can impact the broader market.

Becker believes there may not be much of a change to the balance sheet moving forward: "I don't think there's an expectation that the Fed is going to rock the boat on its balance sheet portfolio from here. They made that big move in June. But you have heard some kind of rumblings about the composition of the balance sheet. So how long the duration is of the bonds that are on the portfolio, how many mortgages are on the portfolio. And so as, as we go quarter to quarter, this is definitely a slow, development that I think matters."

For more expert insight and the latest market action, click here to watch this full episode of Catalysts.

This post was written by Nicholas Jacobino

Video Transcript

And there's a lot of focus always on the fed's interest rate decisions, but we kind of forget about that other big tool for the fed, which involves the feds balance sheet.

The FO MC has reduced its balance sheet draw down recently that does remain above pre pandemic levels here to discuss how this could impact the broader market.

We've got to be, he is Black, senior portfolio manager on the global Tactical asset allocation team to it.

It's great to speak with you.

I wonder if you relate to this.

My friends, my mom, when they asked me about the Fed, they are always asking me about when we're going to get that rate cut.

They never talk to me about the feds balance sheet.

What do investors need to know about the feds other big tool?

Thanks, Maddie.

Yeah, nice to be here today.

Uh a big week as, as you laid out.

Um So in June, if you remember the, the fed taper, the size of its QT program, so that chart you just showed uh the size of the balance sheet has been declining.

Uh For a couple of years here, we've done some analysis kind of over the last few months trying to disentangle the degree to which that balance sheet tightening has transmitted into financial markets.

And the conclusion we've come to is this QT two kind of this second round of quantitative tightening hasn't quite tightened as much as maybe intended.

That can help to explain why the economy's been so resilient, so robust.

Uh and uh maybe has defied some of the Fed's expectations when they set the pace.

So an element of this is starting in June, uh the FED is actually gonna be reinvesting a larger share of the balance sheet.

So initially, they were running down about $60 billion a month of treasuries off the balance sheet.

They've tapered that back.

Uh So only 25 a month and that has an impact on fiscal policy as well in this environment.

So some uh events this week that we're gonna find out about uh how much Janet Yellen and the Treasury are going to issue this upcoming quarter, how big the auction sizes are gonna be?

And so to the extent that the fed has tapered, the size of that qt means that investors won't have to come in and take down his larger share of those auctions because the FED is going to be rolling that large balance sheet that they have.

So $6.6 trillion still a materially large balance sheet and still impacting financial markets in an ongoing way.

Tom, I hear what you're saying here.

And to me, it feels like a sneaky risk that not a lot of people are paying attention to.

Is anything that you're saying right now is any of this priced into stocks?

Uh I, I think it is, it's, it's broadly priced into financial markets uh right now and I don't think there's an expectation that the FED is gonna rock the boat on its balance sheet portfolio from here.

They, they made that big move in June.

Uh But you have heard some kind of rumblings about the composition of the balance sheet.

So how long the duration is of the uh bonds that are on the portfolio?

How many mortgages are on the portfolio?

And so as as we go quarter to quarter, this is definitely a slow uh development that I think matters.

Uh the the balance sheet of course impacts the term premium.

The comment we just had about the inverted yield curve for years here.

A part of that's related to the fed, having suppressed long term yields, having bought a lot of the duration out of markets.

And so to the extent that kind of that that the four rounds of quantitative easing operation twist all these successive programs since the financial crisis, that does have an ongoing effect on financial conditions, we think that is underappreciated.

Uh don't see it as a risk here in the next couple quarters.

But as as we move forward, if the economy remains resilient if a couple rate cuts kind of reignite economic activity.

Uh I, I think the balance sheet could come back into question again next year as uh you know, what do we want the steady state to be?

What do we want the composition to be?

These are things we're thinking about on the team.

Uh Since we focus mostly on fixed income, we're thinking about the steepness of the yield curve.

Uh this last month, we've seen kind of stocks, uh not take some of this steeping of the yield curve that well.

Um And so I do think that's a risk something we saw in Q three of last year, kind of the steen of the yield curve being bad for stocks and bonds.

Certainly something we're keeping on our radar.