Fed balance sheet: Watching paint dry?

Around the Curve

Fed balance sheet: Watching paint dry?

Given what's actually in the Fed's inventory of securities, is the current plan for selling it off too risky?

My colleagues have blogged extensively about quantitative tightening (QT) and the cadence of rate hikes leading up to the December Federal Reserve (Fed) meeting. Let’s take a closer look at the contents of the Fed’s balance sheet to determine whether it could actually slow down the pace of QT or rate hikes. 

Chart 1 below shows the Fed’s total System Open Market Account (SOMA) holdings, which declined from $4.204T on December 27, 2017, to $3.858T on December 26, 2018. That’s a $346B balance sheet reduction in 2018, comprised of $227B of Treasuries and $128B of mortgage-backed securities (MBS). To aid this process, the Fed introduced caps which were designed to limit the reinvestment of maturing securities, and as the cap increases, the amount of reinvestment decreases.


Source: Bloomberg, as of 12/31/2018. See below for definition of SOMA. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


As we know, the $50B per month runoff cap recently took effect in October 2018. Prior to that, the runoff caps for Treasury and MBS redemption were much lower, starting from the low level of $20B per month in 1Q 2018. These lower runoff caps suppressed the speed of balance sheet reduction in the first three quarters of 2018 (see Charts 2 and 3).


For Charts 2 and 3:  Source: Federal Reserve Bank of New York. Notes: Figures are monthly. Figures for January through May 2017 are historical maturities. The maturity profile is associated with the median liabilities scenario. Projected figures are rounded. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Even with that suppression, the actual balance sheet runoff was still slower at $346B than the suggested $470B embedded with the runoff caps. Since the Fed’s first hike in December 2015, QT seems to have taken the approach of “faster rate hikes and slower balance sheet unwinding” with nine hikes already and only 74% of the planned balance sheet runoff.

Therefore, Fed and market expectations may be misaligned, where the central bank perceives the pace of QT as slow and investors think it’s too quick, particularly given the number of increases to the fed funds rate. Given the runoff rates in 2018, the situation may change in 2019, as the balance sheet reduction could accelerate from here as the maximum runoff caps are phased in.

Will the Fed take the opposite approach of “slower rate hikes and faster balance sheet unwinding” this year? While the amount of maturing Treasury securities can be projected with certainty, the principal pay-downs of MBS are model-based estimates due to the embedded prepayment option, driven by variables like the path of interest rates, housing price movements, mortgage credit conditions, and employment situations of homeowners, etc.

Based on the maturity schedule, the Federal Reserve Bank of New York (see Chart 2) projected Treasury redemption could reach $262B—assuming normal maturity and subject to the caps—and the projected MBS reduction hovers around $163B; however, a 200 basis point downward rate shock to the mortgage rate could push MBS runoff to exceed $240B.

So in its base scenario, we can get $425B reduction, a 23% increase from the $346B in 2018.

We believe the increase in the speed of the Fed balance sheet runoff could have a significant impact on the market, especially the long-end of the Treasury curve, as most of the Fed’s holdings are long-dated.

With almost all major central banks reversing quantitative easing—including the European Central Bank’s recent coda to its asset purchases—we could face more of a dollar liquidity shortage.

These are just a few reasons why the Fed should consider taking it slow with regard to both forms of tightening; given Chairman Jay Powell’s recent comments on January 4, we think he and other Fed officials are finally open to reevaluating this pace.



The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.

Quantitative tightening (QT) refers to policies design to reverse the flow of central bank reserves, reducing the excess reserves by selling from their inventories of debt securities.

The Federal Reserve’s System Open Market Account (SOMA) is managed by the Federal Reserve Bank and contains assets acquired through operations in the open market. The assets in the SOMA serve as a management tool for the Federal Reserve's assets, a store of liquidity to be used in an emergency event where the need for liquidity arises and as collateral for the liabilities on the Federal Reserve's balance sheet, such as U.S. dollars in circulation.



Important Information


All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

Asset-backed, mortgage-backed or mortgage related securities are subject to additional risks such as prepayment and extension risks.