Couple more thoughts on balance sheet run-off

Correction: Under my new rules of blogging, I can’t just go correct this in the post from yesterday.  So here goes.

In my post on Tim Duy’s take yesterday, I took him at his word that the Fed had suggested that ending reinvestments might be worth 15 bps on the 10-year Treasury yield during 2017. And I pointed out that might be true, but that it was an odd estimate. I then related the oddity of that estimate to inconsistency at the Fed. That was unfair to the Fed. In fact, what Yellen had actually said in a footnote to her speech of Jan. 19 was this with emphasis added:

17. Based on estimates generated using the term-structure model developed by Li and Wei (2013) and the procedure discussed in Ihrig and others (2012) and extended by Engen, Laubach, and Reifschneider (2015), the Federal Reserve’s holdings of Treasury securities and agency mortgage-backed securities continue to put considerable downward pressure on longer-term interest rates. However, this pressure is estimated to be gradually easing as the average maturity of the portfolio declines and the end-date for reinvestment draws closer. Over the course of 2017, this easing could increase the yield on the 10-year Treasury note by about 15 basis points, all else being equal. Based on the estimated co-movement of short-term and long-term interest rates, such a change in longer-term yields would be similar to that which, on average, has historically accompanied two 25 basis point hikes in the federal funds rate.

That is not actually about the impact of suspending reinvestment. Rather, it goes to a point I address in this post, immediately below. Sorry for the error.


There is now heightened interest in how the Fed will achieve a presumably-passive contraction of its balance sheet, once the central bank decides that the time is appropriate.

From an economics or policy perspective, this whole discussion is probably a distraction.  As Tim Duy has emphasized, correctly in my view, whatever the Fed does on balance sheet policy will be coordinated with rates policy to avoid an excessive tightening of overall policy.  Of course, there remains the risk that the Fed will go too far, as it has arguably * and ultimately done in most cycles.  However, there is little reason to believe that the presence of the balance sheet issue should increase this risk.

More to the point, and IMV, policy analysts and Wall Street types have radically overstated the importance of the balance sheet anyway.  QE was not the main – or even important – reason bond yields remained historically low after the Crisis.  The taper tantrum was much more about rates signaling than about the size of the balance sheet, as former Fed Chairman Bernanke has recently conceded.  And looking forward, bond yields are not likely to be importantly influenced by the announcement of balance sheet run-down, beyond probably a transitory knee-jerk reaction, which will confuse those who still believe in the relevance of event studies. 😉  I have been over all these issues before, which is not to say that the issue is therefore resolved, but just to say that I will not dwell further here.

This note is not about trying to get you to dial up the importance you attribute to the balance sheet. I would rather you dialed it way down, leaving room only for the temporary greater-fool / beauty contest dynamic that, yes, will probably attend the announcement to allow run-off.

Instead, I would like to make just a couple quick points to further reinforce my view that the QE discussion involves a lot of smoke and mirrors.  First, the Fed leadership has made a big stink about maintaining a steady nominal size of the balance sheet until it has decided that the “tightening” associated with allowing run-off is appropriate – in the context of whatever is happening on rates policy.

At the same time, however, they are making no effort to maintain a steady duration in their Treasury portfolio. Rather, they are matching the reinvestment purchases to the pattern of Treasury issuance.  That is odd. They claim that QE operates by taking default-free rates duration out of the market, so one would think that the thing they would hold constant would be aggregate duration, rather than the nominal size of the balance sheet.

I hasten to add that this is not a big deal.  Treasury issuance is not so different from the average maturity of the Fed’s existing portfolio, so this laxity should not allow average duration to move much. (The data on that exist, but just not for me, yet.) Plus, to belabor the point, manipulation of duration on the Fed’s balance sheet has no obvious effect on bond yields anyway.

So this just highlights yet another inconsistency between the story Fed officials have told about how QE works and how they actually manage their operations around QE.

Second, Zero Hedge reports that Goldman speculates that the Fed will not allow passive run-off until 2018, but might in the meantime proactively shorten the maturity of its Treasury purchases.  This is from January 19:

Overnight, Goldman too decided to opine on the rising debate of what happens next to the Fed’s $4.2 trillion balance sheet, and cutting to the case, says that it continues to expect full reinvestments to end in the middle of 2018 (i.e., no runoff for at least 18 months), but adds that while “we would be very surprised to see a discussion of asset sales under Chair Yellen’s leadership” a shift to “more active management of the maturity of new Treasury purchases could be an option; shortening the duration of new purchases would quicken portfolio runoff once it begins.”

Unpacking that, Goldman mentions that there would be two effects to shortening the maturity of Treasury reinvestments.  First, the duration of the purchases would also shorten immediately, and with it, that of the Fed’s overall portfolio.  And secondly, yes, the nominal balance sheet run-down would be quicker under this scenario, once the Fed has decided to begin it.

It is important to recognize that those are separate effects, and that the first is by far the most important, at least according to the official story the Fed tells about how QE works (which I reject, which is ultimately my point here).

The vast majority of the impact on bond yields is (presumably) delivered when the Fed decides to shorten the maturity of purchases.  How that later interacts with the decision to start passive run-offis entirely secondary. Any security, regardless of maturity, shortens by a day per day, when measured in maturity terms, and duration is not so different when interest rates are low. Plus, even the Fed would concede that net supply matters much less for yields at the shorter maturities. **

So why doesn’t Goldman emphasize this, that the impact of shortening reinvestment maturities comes immediately, rather than when the Fed allows passive run-off? I don’t know.  And I hasten to add I don’t think this is some huge oversight by Goldman.

I suspect people might not pay much attention to this because they intuit what I do: that this whole issue just is not that important. It is something that people who get a kick out of mentioning large numbers, like $4.2 trillion, like to dwell in, pretty pointlessly, in my view.

The Fed leadership is worried about the political symbolism of the balance sheet.  They may be a little worried about income losses in the event that rates spike, and their securities go negative carry. And they may be concerned about the knee-jerk reaction when they decide to allow passive run-off, even though that should be sufficiently transitory not to affect the economy, in my view.

But I think this would all be clearer and easier to understand if you just got out of your heads that bond yields are low because of the balance sheet and that shrinking it will be the reason for them durably to rise.

Not to be bullish bonds. That is a separate discussion.

* There is a semantical sense in which this is inevitably the case. If you believe that recessions are killed by Fed tightening or by the failure of the Fed to ease to prevent them, then every cycle ends with excessively tight policy.  But I am not sure that is necessarily a practically useful way to look at it, and I would rather not get into that here.

** Given the second point mentioned there, the decision to shorten the maturity of reinvestment purchases could actually lessen the incremental importance of nominal portfolio run-off, once the Fed decides to start it. Shortening from five years plus a day is arguably more important than shortening from one day to maturity, within the Fed’s official sense of how this all works. But for me, that would be the minutia around the minutia.

Full disclosure: I have occasionally been chided by former colleagues for writing too much about QE. It is over, so why dwell? The practical reason — which I would prefer to emphasize — is that the relative unimportance of the Fed balance  sheet actually affected things after it was over. For example, the “stimulus” from the “bloated” balance sheet did not actually increase the need for an early rise of the fed funds rate, despite people’s expectations to the contrary. (Remember the shadow funds rate? LOL) More memorably, QE was not an easy/reliable way to get around the zero bound, so the Fed would have to risk manage away from a contractionary policy error.  And the taper ended up not mattering, although the pre-taper tantrum was a fun experience! And now, the focus should not be on how quickly the Fed shrinks the balance sheet.  So it is not like this stuff is practically irrelevant. Knowing that the balance sheet is no biggie is actually a pretty big deal.

But let’s be honest, there is ego involvement here. So let me tell an anecdote related to that.  While QE3 was ongoing, a bucket shop invited me to a presentation on QE made by a fellow who had previously managed the QE portfolio. The Fed guy used to tell a joke that went something along the lines that he was the biggest hedge fund manager in the world who charged 0 and .00000000001.

I really don’t want to mention the bucket shop, beyond pointing out that its economist had an amazing sell-side ability “basically” to agree with everybody. Former Fed guy explained to an utterly incredulous audience (minus me) that QE was not that big a deal, that it was not inflationary, and that its purpose was only to push down the term premium in bond yields, which looked a lot like conventional monetary policy. This brought polite guffaws, from a bunch of angry bears who were upset that the Fed was ruining a perfectly good economic collapse by “rigging the markets.”

When it came time for me to throw in my two cents, I mentioned that I had a disagreement with Fed guy but from the exact opposite end of the spectrum.  To me, QE was not just not dangerous, but pretty much pointless beyond its rates signaling and temporary greater fool effects.  Maybe the other guys in the room did not like the sound of being described as fools, * even great ones, who worked at hedge funds.  Ewwwww.  But man was the reaction negative.

That night I decided, I am going to prove that this is all bullshit. Part of it was that equities would not collapse when the Fed tapered. I had to pretend there was SOME practical purpose beyond mere ego protection.  But mostly it was a combination of contrarianism and just being pissed off by the (ex-Brian)  room’s combination of arrogance, utter ignorance and — well — impoliteness.

Plus, I have often been the fool. I think they should have a reunion.

On another occasion I was invited to dine with the masters of the universe because my boss could not go and gave me the seat. I did not know they were the masters of the universe, because I don’t pay attention to personalities. That anecdote reflects quite a bit worse on me, so I will never share it. But I remember laughing ruefully when a manager back at home office gave me shit and told me who they were. Oops.

* Strictly speaking, I was not calling them fools. I was describing as actors on the greater-fool theory the luckier guys who had bought for the wrong reason, and presumably expected later to sell once the super important QE ended. I don’t know, but I would guess QE affected the timing but not extent of the rally. In the early 20 teens that was a very unpopular idea. I remember one hedge fund kid from central casting — rock star hair, top three buttons of dress shirt undone — saying, you don’t think monetary policy matters?! He thought QE and monetary policy were the same thing, entirely overlapping sets.