Markets are eagerly awaiting the Fed’s plan to shrink its $9 trillion balance sheet. They should get their wish on Wednesday

Markets have been craving information on how the Federal Reserve plans to shrink its massive $9 trillion balance sheet. They will get their wish on Wednesday when the Fed releases the minutes of its March meeting.

Last month Fed Chair Jerome Powell said the central bank had made “excellent progress” on the balance sheet and the parameters would come with the minutes.

“We will have some information tomorrow, hopefully enough to satisfy the market,” said Kathy Bostjancic, director of US macro investor services at Oxford Economics.

She said she was worried the market was expecting too much.

“They’re going to give us the basic plan, whether they’re going to give us the details, I’m a little skeptical,” she said.

The Fed’s balance sheet doubled to $9 trillion during the pandemic as the central bank bought trillions of Treasuries and mortgage-backed securities, first to bail out a faltering U.S. bond market and later to help the economy recover.

According to the Fed, the large balance sheet is pushing long-term interest rates down – which is boosting the economy. This is no longer appropriate as inflation is at its highest level in 40 years.

The implications of balance sheet shrinking – dubbed by some as quantitative tightening – are not well understood.

“By no means does anyone have an extraordinarily clear idea of ​​what the unwinding of the balance sheet — especially as large as it is now — is going to do to financial markets and the economy,” Seth Carpenter, Morgan Stanley’s chief global economist, told a recent NABE -Conference.

Markets and the Fed are a bit nervous about the balance sheet shrinking process.

On Tuesday, the yield on the 10-year TMUBMUSD10Y Treasury note rose 2.559% after Fed Governor Lael Brainard said the Fed would “quickly” trim its balance sheet. Stocks fell, with rate-sensitive technology-related stocks leading the way lower as the Nasdaq Composite COMP, -2.26%, tumbled more than 2%, while the S&P 500 SPX, -1.26%, fell more than 1% and the Dow Jones Industrial plunged The average DJIA, -0.80% lost 0.6%.

The Fed has only shrunk its balance sheet once, from 2017 to 2019. It was doing well until it couldn’t.

As of October 2017, the Fed was able to shrink its balance sheet from $4.2 trillion to $3.6 trillion. But in September 2019, volatility in money markets forced the Fed to quickly halt balance sheet shrinking and buy Treasuries to inject liquidity into the banking system.

The Fed is hoping this time will be different. To protect against volatility, the Fed set up a facility where banks can turn to the central bank for emergency reserves.

At this time, the Fed has no plans to sell any securities on its balance sheet.

Instead, the Fed rolls maturing securities off the balance sheet and doesn’t reinvest the proceeds.

Philadelphia Fed President Patrick Harker has said he wants the balance sheet to become so boring it’s like “watching paint dry.” The goals are to set it and forget it.

To keep the process orderly, the Fed has set monthly “caps” on how many securities can expire.

That’s almost double the monthly pace of quantitative tightening of $50 billion in 2017-2019.

Wall Street believes that after a slower start, the Fed will eventually drain $80 billion to $90 billion a month — maybe $50 billion in Treasuries and $30 billion in mortgage debt.

One difference this time is that the Fed has T-bills on its balance sheet.

Economists generally expect the Fed to aim to reduce its balance sheet by $3 trillion over three years.

This is a big adjustment for the markets. By mid-2025, retail investors will need to hold $3 trillion in government bonds and mortgages.

The Ministry of Finance also plays a role in this process. With the Fed stopping buying debt, the Treasury must decide where along the yield curve to issue debt.

The mortgage market loses a large price-sensitive buyer.

Minutes are not expected to announce the start date for the runoff. Analysts see a good chance that this will be announced after the next Fed meeting on May 3rd and 4th.

The minutes could also provide clues as to what would prompt the Fed to hike interest rates by 50 basis points in May.

Since the March meeting, many Fed officials have said that a half-point hike will be “on the table” at the May meeting. Some economists feared that beginning quantitative tightening along with a 50 basis point rate hike would be too aggressive.

“The minutes probably won’t settle the question of how big the May rate hike will be, but only because the committee itself isn’t sure yet,” said Lou Crandall, chief economist at Wrightson/ICAP, in a note to clients.