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July 21, 2023 | 12:48
Fed and BoC Balance Sheets: Larger for Longer
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Fed and BoC Balance Sheets: Larger for LongerNext week, the Federal Reserve is widely expected to lift the target range for the fed funds rate by 25 bps to 5.25%-to-5.50% and roughly repeat (from June) that it will “continue reducing its holdings [of securities]”. Last week, the Bank of Canada raised the target for the overnight rate by 25 bps to 5.00%, stating that it is “continuing its policy of quantitative tightening”. Although rate hikes could soon come to an end (if not this month), quantitative tightening (QT) looks to continue for a lot longer. |
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After rate hikes commenced in March 2022, both central banks quickly began QT. Effective April 25, the Bank of Canada stopped reinvesting all proceeds from its maturing Government of Canada bonds. Beginning June 1, the Fed began reinvesting only monthly amounts above $30 billion for Treasuries (not including bills and FRNs) and $17.5 billion for agency mortgage-backed securities (MBS). This was raised to $60 billion and $35 billion, respectively, three months later. The QT programs have been running in tandem with rate hikes ever since, even when the latter have been conditionally paused (the BoC in March and April) or skipped (the Fed in June). |
Central bank securities holdings are shrinking as government bonds mature and aren’t replaced (and, for the Fed, as mortgage principal is paid but not reinvested). There are no outright sales of securities. While this pares down potential potency, QT is still complementing rate hikes in contributing to tighter financial conditions along with normalizing balance sheets. In the wake of the pandemic, central bank balance sheets ballooned owing to quantitative easing (QE) along with other measures to support market liquidity and credit availability. (Note that for both the Fed and BoC, these other measures peaked in June 2020 and had mostly wound down well before QT commenced.) For the Fed (Chart 1), after QE wound down in early March 2022, only days before the inaugural rate rise, holdings of Treasuries and MBS peaked at $8.50 trillion, $4.66 trillion above where they were at the end of February 2020 (up 121%). They are now $7.62 trillion, down $881 billion after 13 months of QT. Compared to their pre-pandemic level, the Fed’s total assets also more than doubled to $8.97 trillion by the April 2022 peak; they are now $8.27 trillion, down ‘only’ $691 billion. The balance sheet impact of QT has been partly offset by Fed lending tied to the banking sector stresses that emerged in March (lending via the new Bank Term Funding Program, FDIC advances and the discount window). In the first two weeks, this lending soared by $339 billion, but it’s now down to $257 billion. |
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The Fed had previous experience with QE (three rounds during 2009-2014) and QT (2017-2019), but this was the Bank of Canada’s first foray into these unconventional measures (Chart 2). After QE ended in late October 2021, more than four months before the Fed, holdings of Government of Canada bonds (both direct and guaranteed) eventually peaked at $449 billion. This is $369 billion above where they were at the end of February 2020, or up a whopping 456% [1]. Previously, the Bank only held bonds for long-term balance sheet management purposes. These holdings are now $317 billion, down $133 billion after 17 months of QT. Compared to its pre-pandemic level, the Bank’s balance sheet peaked in March 2021, up 373% to $575 billion, well before QE ended (unlike the Fed). Apart from steadily mounting bond purchases, other measures to support market liquidity and credit availability (which included treasury bill buying) surged to hit $312 billion by June 2020. They subsequently started to be reduced but still stayed elevated until the spring of 2021. The balance sheet is now $358 billion, down $218 billion from its pandemic peak. On QT Quitting Time |
With central bank securities portfolios still very large relative to pre-pandemic levels, there would appear to be ample room for QT to run for a long time. For example, we estimate the Fed’s holdings averaged 29.0% of GDP in Q2, compared to less than 18% in 2019 (Chart 3). The Bank’s holdings averaged 11.6% of GDP in Q2, compared to a steady 4½% in the years before the pandemic. However, it’s not portfolio size per se but how the reduction of holdings impacts the level of reserves (for the Fed) or settlement balances (for the BoC) that determines how much QT room remains. Once reserves or settlement balances have returned to levels deemed by the central banks to be optimal, QT will stop. Unfortunately, there’s uncertainty surrounding where the optimums are. |
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For the Fed, reserves are currently $3.22 trillion and likely averaged 12.1% of GDP in Q2. And, at least there's a clear lower bound for reserves. During the first QT episode, they decreased to a point where liquidity in the overnight lending market became severely constricted [2]. Indeed, QT was ended two months ahead of schedule, on July 31, 2019, accompanied by a policy rate cut. Although the early ending was primarily because rates needed to be cut which would be inconsistent with QT (recall the Fed cut a total of 75 bps in 2019 H2), overnight lending pressures were beginning to emerge as reserves were starting to become ‘scarce’. The issue came to a head mid-September when SOFR spiked, doubling to 5.25%. The Fed eventually started regular (technical) T-bill purchases to rebuild bank reserves, which continued until QE ramped up in the wake of the pandemic. Keeping reserves well above 7.0% of GDP or $1.9 trillion was the lesson learned. Indeed, the Fed has already indicated that it intends to stop QT with reserves remaining well above this threshold and allow the growth in other liabilities such as currency and Treasury deposits to slowly steer reserves lower while keeping assets constant. But there’s another wrinkle: the $1.74 trillion currently in the Fed’s overnight reverse repo (ON RRP) facility, mostly from money market funds (MMFs) (Chart 4). While there are several reasons for the rise in activity [3], how these balances behave going forward could quicken the downward adjustment in bank reserves (if ON RRP take up stays elevated or rises further) or slow it down (if it falls). |
However, with the interest rate environment shifting from rapid-fire rises (think four consecutive 75 bp policy rate hikes) to less frequent/smaller moves and soon stability and eventually rate cuts, the previously-dampened demand by MMFs for (term) T-bills owing to the fear of capital losses is being re-whetted. Indeed, the recent near-$490 billion re-building of Treasury’s bank account at the Fed after the debt limit was lifted was done via T-bill issuance with reduced ON RRP take-up absorbing nearly all of it. This suggests these balances could continue declining as the shifting rate environment unfolds, potentially providing additional QT room as reserves reduction is slowed. For the Bank of Canada, settlement balances are currently $172 billion and likely averaged 6.4% of GDP in Q2. Unlike the Fed, BoC QT is more readily reflected in lower settlement balances (of course, movements in currency and federal government deposits can alter things a bit like the Fed). Deputy Governor Gravelle, in a March 2023 speech [4], said “our best estimate [of the long-term demand for settlement balances] is somewhere in the range of $20 billion to $60 billion, or roughly 1% to 2% [of GDP]”. And, given the schedule of bond maturities, “this will likely occur sometime around the end of 2024 or the first half of 2025.” There must have been an implied ‘ceteris paribus’ assumption here because another QT constraint looms potentially sooner for both the BoC and the Fed… a monetary policy shift into an easing gear. |
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QT is inconsistent with rate cuts. The Fed showed this in July 2019 (and the opposite, QE being inconsistent with rate hikes, in March 2023). Meanwhile, unlike the Fed, the Bank has elevated QE and QT to headline status in policy announcements, so we suspect it would be even more leery to tarnish a 41-month record of consistently applied policy tools. We’re expecting rate cuts to commence during 2024 Q2, after economic growth stalls through the turn of the year on both sides of the border, which is when we expect QT to end. In the meantime, central bank securities holdings will continue maturing with the proceeds not being reinvested. But come 2024 Q2, we reckon they will start being reinvested again. For the Fed, the proceeds are regular (Chart 5). Until QT ends, maturing notes, bonds and TIPS will be supplemented by T-bill redemptions to ensure monthly QT amounts come in around $60 billion. Once QT ends, and if the previous episode is any guide, reinvestments will be apportioned across auctions on a monthly basis to keep holdings roughly constant. Note that the Fed will likely continue not reinvesting mortgage principal payments and replace them with Treasuries to keep the total portfolio unchanged. These payments have been coming in short of the monthly $35 billion cap (Chart 6), as high and rising mortgage rates have crimped home sales and refinancing activity. |
For the Bank of Canada, the proceeds from maturing securities are choppier and much larger than anything experienced before (Chart 7); such is the legacy of a 456% explosion of holdings. While the Bank will also apportion these across auctions, it will likely be beyond a monthly cycle, perhaps in line with the quarterly auction schedule to avoid having too much influence at individual tenders. This should give rise to an intra-cycle ratcheting profile, with holdings increasing before and after bonds mature to keep the portfolio roughly constant over the cycle. Bottom Line: For the Fed and BoC, balance sheets, securities holdings and reserves/settlement balances are all going to be stabilizing at levels well above where many analysts had originally envisaged. It could be a while before these amounts resume mounting as both central banks ‘grow’ into them. Endnotes:[1] Note that this figure does not include treasury bill holdings, which surged by $115 billion during the first five months of the pandemic. However, that had more to do with liquidity provision than QE, and they were subsequently reduced. And, they’ve been zero since April 2022. [^][2] Owing to regulatory changes (compelling banks to hold more liquidity) and changes to banks’ balance sheet management practices (wanting more of their liquid assets in the form of deposits at the Fed), the aggregate amount of reserves banks wanted to hold for their own liquidity management purposes was uncertain. Also unknown was the point at which more tentative overnight lending would be triggered. [^] |
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[3] During 2021, amid continued liquidity creation via QE, flush MMFs found relatively fewer traditional places to invest their funds. For example, banks became more cautious about overnight repo and deposits after leverage rules, that were relaxed after the pandemic’s onset, were reinstituted. And, Treasury’s financing share via bills was dipping. So they turned to the ON RRP facility and stayed there as money market rates began to rise sharply as a safe haven against potential capital losses on money market instruments such as T-bills.[^][4] https://www.bankofcanada.ca/2023/03/market-liquidity-programs-lessons-pandemic/ [^] |