After a hotter than expected inflation print for the month of May and a FOMC meeting set to occur this week, most of the coverage has been focused on Jay Powell and his intentions to alter interest rates. It is thought that the Fed will raise rates 50 bps, with economists from Jeffries and Barclays calling for a 75-bps hike, but occurring in conjunction with this is the Fed starting the reduction of their balance sheet.
Also known as quantitative tightening, the Fed, starting in June, will begin to allow maturing securities to “roll off” the balance sheet by not reinvesting the proceeds.
The goals of the Federal Reserve Bank are known as the “dual mandate” which are promoting maximum employment and stable prices. One of the mechanisms to help accomplish this goal is using their balance sheet.
Like a balance sheet for any company or person, it is made up of assets and liabilities. On the asset side of the balance sheet, the Fed holds treasury securities, mortgage-backed securities, and loans made through the repo and discount window. On the liability side, there is the currency in circulation, bank reserves on deposit with the Fed, and reverse repo agreements. They use this to influence prices and yields of securities. By buying assets, the Fed increases prices which decreases yield, and by selling assets they decrease prices which increases the yield of the security. For many years, the Fed balance sheet was mostly stable and grew in line with the rising amount of currency but that was no longer the case after the Federal Reserve's response to the GFC.
Following the breakdown of the economy and financial markets in 2007-2008, the Fed wanted to act strongly to prevent a full-scale meltdown. They cut rates to rock bottom levels but that wasn’t enough to right the ship. The next step came with quantitative easing, or the large-scale purchases of assets by the Federal Reserve Bank. To bring down long term interest rates and to signal looser monetary policy to the market, the Fed undertook “QE1” beginning in November of 2008. The first round of asset purchases, which concluded in March of 2010, consisted of over $1.7 Billion in asset purchases. After an additional two rounds of QE, the Fed balance sheet had ballooned from about $870 Billion to about $4.5 trillion but it helped accomplish their goals with some studies showing it reduced long term treasury and mortgage rates by about 1 percent.
The expansion of the Fed balance sheet to historically high levels was never supposed to be permanent, with plans to reduce the size when the economic outlook was better. By 2017, the Fed was ready to begin the process of reducing the size of its balance sheet. There are two ways to go about this process, one being the direct sale of assets from the balance sheet and the second way is to let assets mature and not reinvest the proceeds. The Fed picked the latter of those two and began allowing $50 Billion, $30B of Treasuries and $20B of MBS, a month to “roll off” the balance sheet. This continued until 2019 when, after getting about $700 Billion in assets off the balance sheet, problems began to occur in the financial markets. In mid-September 2019, the overnight money market rates spiked dramatically, showing signs of distress. This led the Fed to change course and begin buying $60 Billion in Treasuries a month which led up to the largest balance sheet expansion in history.
Following the COVID pandemic crushing the US economy, the Fed was forced to act and resume QE. On March 23, 2020, the Fed said it would purchase $500 Billion in Treasuries and $200 Billion in government backed MBS, with that shortly changing to purchases “in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.” By the end of the buying, the balance sheet had more than doubled in size to just under $9 trillion but the Fed began plans to reduce that figure starting in June 2022.
In a May press conference, Fed Chairman Jay Powell laid out the plans for this round of balance sheet reduction. Starting in June, the Fed will not reinvest $30B of maturing Treasuries and $17.5B of agency MBS a month with those amounts doubling after three months. By not reinvesting the proceeds, the Fed creates a demand void in the market, pushing security prices lower and yields higher. While admitting that the effects of this are “uncertain”, Powell estimates that one year of QT at this pace would be about the same as a 25-bps rate hike. This process is slated to last longer than one year so the longer-term effects on interest rates could be even more pronounced, having impacts on the net lease real estate market.
As when the Fed engages in rate hikes, cap rates move with interest rates as they increase. As the cost of money becomes more expensive, there are less buyers in the market with supply remaining constant or increasing, putting downward pressure on prices. The combination of 40-year high inflation, rising rates, and QT leaves investors in an unprecedented position but one that will most likely differ greatly from the past 10 years of easy money and rock bottom interest rates.
This article follows our previous coverage of Interest Rate hikes, covered by Senior Associate Zach Lesko.
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