by Jeff Weniger, CFA Head of Equity Strategy, Kevin Flanagan Head of Fixed Income Strategy, WisdomTree
The financial markets have been laser-focused on upcoming policy decisions from the Fed, and rightfully so. Following the resumption of the current rate cut cycle, investors have been wondering what exactly this second phase will ultimately look like. While the government shutdown has created a new layer of uncertainty into the equation, the markets are poised for another quarter-point reduction in the fed funds rate trading range at the FOMC meeting at the end of this month.
However, what oftentimes gets lost in the broader monetary policy picture is the Fed’s balance sheet. Specifically, we’re talking about the Fed’s System Open Market Account or SOMA. These are the line-items which contain the U.S. policymaker’s holding of U.S Treasuries (UST), mortgage-backed securities (MBS) and federal agency securities.
An interesting point that does not get discussed is that while Powell & Co. are currently in the business of cutting rates, they are also continuing down the road of quantitative tightening (QT). This was not an unexpected development as Fed officials had previously stated that these two policy approaches could co-exist, and that is exactly what is happening.
The current QT operation is now well over two years old as it had its start date in June of 2022. While SOMA includes the three aforementioned security classes, this round of balance sheet reduction only includes the Fed’s holdings of UST and MBS. Back in June 2022, the Fed’s total holding of all securities was an eye-opening $8.5 trillion. Of this overall amount, UST came in at $5.8 trillion, MBS at $2.7 trillion and federal agency securities were ‘only’ $2.3 billion.
As of October 8th, of this year SOMA had been reduced by $2.2 trillion to a new total of $6.3 trillion. UST holdings have been pared back by about $1.6 trillion while the MBS tally was reduced by $600 billion. If you’re keeping track, that leaves the current UST and MBS amounts at $4.2 trillion and $2.1 trillion, respectively.
While the amount of QT that has already occurred may seem noteworthy, the Fed’s total SOMA holdings were about $4.25 trillion at their peak post financial crisis, or about the same level that total UST holdings are at just by themselves right now. As for what the future holds, the Fed is still embarking on its QT program. At the September FOMC meeting, the policymaker re-stated that it would continue its current pace of balance sheet reduction, where the emphasis is on drawing down MBS at a larger pace than the UST portion. In fact, the Fed has repeatedly emphasized that their ultimate goal would be to have only UST holdings on their balance sheet.
Just to be clear, the current QT program does not involve outright selling of any securities. Rather, the Fed is buying a lesser amount of UST and MBS than what is being redeemed. In other words, it is not ‘fully’ replacing any of SOMA’s maturing securities.
When will the current round of QT end? The money and bond markets had been operating under the assumption that the Fed’s balance sheet reduction would have ceased earlier this year. Based on recent commentary from Chairman Powell, it appears as if it could end in the “coming months”. While the QT end-date may be somewhat of a moving target, one aspect that remains crystal clear is that even when QT does end, the Fed’s balance sheet is still going to be visibly larger than where it was before Covid-related buying began.
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