Why the FOMC minutes are a lie

The math behind the Fed's balance sheet reduction

Imagine for a moment that you are at a car dealership. A salesman approaches you, slaps the hood of the car you are looking at, and lists all the features. You look it over and come to the conclusion that you want to buy this car. The salesman, sensing this, then tells you there is an older model on the lot. You think to yourself, better check that one out, it could be cheaper and just as good. When you see the old one, it looks exactly the same as the newer model. All the same features that you were looking for and it looks to be in great condition. The salesman talks up the previous owner. Some old guy who only took it to the grocery store and church once a week. Looking it over, you come to the conclusion that this is the one. The salesman works up the paperwork and just as you are about to sign he tells you that the older model is more expensive than the newer model. What?! You balk. Why would you pay more for an older model? No, none of this is right. You want the better deal. ‘Give me the newer model’, you’d exclaim. Why would anyone take the older model?

This is exactly why the Fed’s balance sheet runoff is going to fail. No one will want to own the older more expensive model. The Treasuries and mortgage-backed securities that the Fed holds were purchased at low interest rates. As inflation stays hot, the long-end of the yield curve is going to rise. When interest rates rise, bonds lose value. The bonds that the Fed is holding will be down in price. Newer issued Treasuries will look much more attractive. They will be sold closer to par and pay a higher rate. Why would an investor purchase an old bond with a low interest rate over a more recent bond with a higher interest rate? The pool of buyers will dry up and the Fed will be forced to hold these bonds to maturity. Only then will they be able to reduce their balance sheet, if they don’t reinvest the funds. This could turn out to be be a much slower process than many are anticipating.

Here is a breakdown of the maturity dates of Treasuries and MBS on the Fed balance sheet.

Something to keep in mind here, the Fed holds more than just Treasuries and MBS on their balance sheet. They hold municipal notes, central bank liquidity swaps, repo and reverse repo agreements, and other assets too. These make up a small percentage of the Fed’s nearly $8.8 Trillion balance sheet. You can find the full breakdown here on the Fed's website.

As these bonds mature, the Fed can choose to not reinvest the funds. This was the method the Fed used during their last balance sheet reduction which ran from October 2017 through August 2019. It is now the most likely path forward for the current reduction of the Fed’s balance sheet.

Many of the big banks (GS, JPM, etc.) believe that the Fed will be able to raise rates 3-4 times this year. Will the Fed be able to raise rates and reduce their balance sheet at the same time without causing major market disruption? What is their pain tolerance for a market correction? 10%, 20%, 35%? At which point would they step in and bail out the stock market? How quickly would they abandon their rate increases and balance sheet reduction? I’m not a believer that the Fed will have the backbone to allow the market to have the correction it needs to clear out all the bad debt. Debt is what fuels this system. Allowing it to fall off the books ruins their 2% inflation plans.