Don't shrink from the Fed's balance sheet runoff

Bottom line up top

• The U.S. Federal Reserve’s plan to shed pandemic pounds from its balance sheet isn’t a crash diet.?Markets expect the Fed’s upcoming quantitative tightening (QT) to reduce its balance sheet more quickly than previously anticipated, and at a more aggressive pace than the Fed’s 2017-era unwinding of quantitative easing (QE). Even if so, we see little reason for concern. We’ll hear details at the Fed’s May meeting, but we expect QT to be implemented passively and through maturing assets when possible. The Fed has already indicated a maximum pace of $95 billion per month ($60 billion of Treasuries and $35 billion of mortgage-backed securities).
• The U.S. economy can handle it.?Quantitative policy (easing or tightening) allows the Fed to add or reduce liquidity to the financial system when needed. Demand for liquidity was exceedingly high amid the Covid outbreak in 2020, when about $3 trillion of the $5 trillion in QE asset purchases occurred. But that pace declined quickly as the pandemic’s impact on the economy waned. The rate of spending growth in the current recovery has been far stronger than following the 2008 financial crisis, and the reality is that the Fed and other central banks don’t need to hold as many assets.
• QT isn’t happening “on the QT.”?The Fed’s actions are well telegraphed. To us, this suggests the events should hold few surprises for investors and shouldn’t significantly impact portfolio construction strategies.

Portfolio implications

What a difference five years makes.?Today’s backdrop for balance sheet reduction bears little resemblance to the last time the Fed initiated QT in September 2017.

• At that point, the Fed was almost two years into a hiking cycle before it began shrinking its balance sheet, which had ballooned to $4.5 trillion. Today, the Fed has just begun to hike ahead of the anticipated May start of reducing its now nearly $9 trillion of QE-padded assets (Figure 1).
• During the previous runoff, the 10-year Treasury yield fell and the 2-year/10- year curve flattened appreciably (Figure 2). This year, the curve is already flat as QT approaches. We don’t think it will get much flatter or invert in the near term. With inflation at or near its peak, we expect the 10-year Treasury yield to rise a bit more over the course of 2022, to about 2.90%.
• For now, it appears the bond market has priced in the balance sheet runoff and is generally giving more weight to the Fed’s anticipated rate hike trajectory. In fact, over the past week, the 2-yr/10-year curve steepened markedly, meaning that investors may be giving the Fed — as well as the economy — a somewhat stronger vote of confidence.

QT and rate hikes don’t alter our asset allocation views.?Given the positive near-term growth outlook, we continue to favor fixed income spread sectors and credit risk over duration risk. Further potential increases in longer-term yields should benefit floating-rate assets such as loans, as well as shorter-duration categories like high yield credit and select emerging markets. We also see opportunities in preferred securities, which in our view have underperformed more than warranted this year.

For more on our views, click here .