Quantitative Tightening Reduces Treasury and Mortgage Securities
Fed’s Balance Sheet Hits Lowest Point Since December 2020
Total assets on the Federal Reserve’s balance sheet declined by $77 billion in April, reaching $7.36 trillion, the lowest level since December 2020. This reduction is a result of the bank’s ongoing Quantitative Tightening (QT) policy, initiated in April 2022, shedding a total of $1.60 trillion thus far.
After a considerable duration of speculation, the Federal Reserve has now officially announced its plans for QT, outlining the manner and extent to which the process will occur. By initiating a gradual reduction in the size of its balance sheet, the Fed aims to minimize disruption in the financial markets, opting for a cautious approach.
Key Details of the QT
- QT will officially begin in June, kick-starting the balance sheet reduction process.
- The cap for the run-off of Treasury securities has been lowered from $60 billion to $25 billion.
- Mortgage-Backed Securities (MBS) runoff cap remains unchanged at $35 billion.
- In cases where the runoff of MBS exceeds $35 billion per month, the surplus will be substituted with Treasury securities, reflecting the Fed’s goal of phasing out MBS holdings over time.
- It is predicted that MBS will gradually diminish from the Fed’s balance sheet in the long term.
QT by category
1. Treasury Securities: There was a reduction of $57 billion in April. From the peak in June 2022, the Fed has removed $1.25 trillion in Treasury securities, bringing the total down to $4.52 trillion. This reflects a significant decline of 38% in Treasury securities acquired through pandemic QE.
2. Treasury Bills: In April, Treasury bills stood at $195 billion, consistent with the total Treasury securities of $4.52 trillion on the balance sheet. Treasury bills play a unique role in QT. The Fed only allows them to roll off upon maturity when a shortfall of long-term Treasury securities prevents the monthly $60-billion cap from being reached. This roll-off mechanism facilitated an approximate $60 billion reduction in Treasury securities monthly.
3. Mortgage-Backed Securities (MBS): The Fed has observed an MBS reduction of $16 billion in April, contributing to a total decline of $368 billion since the peak. MBS holdings now stand at $2.37 trillion, the lowest level reached since July 2021. This represents a 27% contraction from the MBS acquired during the pandemic QE phase.
The reduction in MBS holdings is primarily attributed to the decline in mortgage refinancing and existing home sales. As fewer mortgages are being paid off due to these market conditions, the passthrough principal payments held by the Fed and other MBS holders have significantly dwindled.
Under the newly implemented slower QT, the cap for MBS runoff will remain at $35 billion. As the housing market recovers and sales volumes return to the norm, the MBS roll-off is projected to intensify, potentially surpassing the $35 billion cap. At such instances, surpassing funds will be replaced by Treasury securities, aligning with the Federal Reserve’s objective to phase out MBS completely from its balance sheet.
Impact on Bank Liquidity Facilities
The Federal Reserve’s discount window, which provides banks with liquidity, recorded a modest increase of $1.3 billion in April, standing at $6.8 billion. However, this value remains significantly lower than the peak of $153 billion witnessed during a bank panic in March 2023.
The Bank Term Funding Program (BTFP), created in response to the 2023 bank crisis, experienced a decrease of $6.4 billion in April. The BTFP contended with a flaw whereby some banks employed it for arbitrage profits, borrowing at a lower market rate and depositing the funds at the Federal Reserve and accruing 5.4% in interest. To prevent this misuse, the Fed modified the rate and the BTFP ultimately expired on March 11, 2024, when it reached $124 billion.
Forecasting the Balance Sheet’s Future
The Federal Reserve is projected to remove approximately $75 billion in assets during May alone, reducing the balance sheet to approximately $7.28 trillion. Once the slower QT process commences in June, the balance sheet is expected to witness further decline. After the initial year of slower QT, by the end of May 2025, the balance sheet is predicted to decrease by approximately $630 billion, resulting in an estimated balance sheet of around $6.63 trillion.
