Note: The following Q&A was published as part of the February 13, 2017 edition of BRIEFINGS. For more insights from Goldman Sachs sent straight to your inbox, subscribe here.
Recent comments from Federal Reserve officials have left investors wondering if the institution is considering its second, somewhat lesser-known form of monetary tightening: balance sheet reduction. Goldman Sachs Research's Francesco Garzarelli, co-head of Global Macro Markets Research, discusses his expectations for a drawdown and the impact it could have on asset markets.
Francesco, we're seeing more discussion of the Fed's balance sheet in meeting minutes and public comments, including remarks from Chair Yellen. What's driving the pickup and why is it significant?
Francesco Garzarelli: I think the two biggest factors are that the US economy appears to be operating closer to full capacity and that the policies the Trump Administration is contemplating -- be it higher infrastructure spending, lower taxes, or measures on trade and immigration -- may add to underlying inflationary pressures. These factors are likely to spur the Fed to tighten monetary policy once uncertainties emanating from Europe, namely the formal start of Brexit and the French elections, subside. This tightening will involve further rate hikes, as is our expectation for 2017, but down the line it could also include a gradual draw down in the size of the Fed's balance sheet -- a second, somewhat lesser-known tightening mechanism. The Fed expanded its balance sheet during the financial crisis by buying up Treasuries and mortgage-backed securities to ease financial conditions, and until recently, the prospect of whittling down the size of its holdings seemed a long way off. But the recent flurry of comments has investors wondering if this approach is on the table.
Do you think the Fed is actively considering balance sheet tightening? And how would it play out?
FG: Not in the near term. Zach Pandl from our US economics team has explored these issues and continues to believe that the Fed will keep the size of its balance sheet unchanged until mid-2018. After that point, we'd expect to see officials start to draw it down by not replacing the Treasuries and mortgage-backed securities that "mature out" of its portfolio. The Fed's standard operating procedure to date has been to reinvest principal payments from maturing securities into new holdings, keeping the size of the balance sheet static. What's interesting about our expectation for a 2018 drawdown is that the amount of the Fed's US$2.5 trillion supply of US Treasuries slated to mature at that point is notably high -- more than a twofold increase from the reinvestment in 2016 and 2017. This would increase the amount the Treasury needs to borrow from the private sector proportionately -- an amount that we already expect to be elevated because of increased fiscal spending.
What are the market implications of balance sheet tightening vs. rate hikes?
FG: Both stand to increase bond yields, but it's difficult to say exactly how much balance sheet tightening could contribute, as we don't have any examples in history. If we look at how much yields declined when the Fed built up the size of its balance sheet, then take the inverse, it seems balance sheet tightening would have a modest effect on yields; only 2-3 basis points on 10-year yields for every US$100 billion of government debt not rolled over. So if we look at 2018, even if the Fed were not to reinvest the whole US$400 billion worth of bonds that mature that year, the impact on US Treasury yields could be inside 10 basis points. But, as we saw with the taper tantrum in 2013, even the prospect of future balance sheet drawdown can have a much larger impact. So once the Fed announces its intention to downsize the balance sheet, investors may look ahead to the total US$2.5 trillion of US Treasuries that the Fed eventually will not roll over. In this case, the impact of "full stock effect" on bond yields could be higher, as much as 50-75 basis points. This wide uncertainty about the impact on yields -- and hence on broader financial conditions -- suggests to us that the Fed will increase short rates further before starting to shrink its balance sheet.
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