Toward a normalisation of the Fed's balance sheet starting this year

After the ‘dovish hike’ in March (rate hike but projections unchanged), the FOMC minutes were awaited mostly for any information they might contain on the subject of a potential normalisation of the balance sheet. You will recall that the Fed had made several massive asset purchases (QE, "quantitative easing") in response to the Great Recession of 2008-2009 and the weak growth that followed. Today, the Fed holds $2,460 bn in US Treasuries and $1,750 bn in mortgage-backed securities (MBS), and it is reinvesting all securities reaching maturity.

As the FOMC minutes show, most of its members were already anticipating that "[p]rovided that the economy continued to perform about as expected, [...] gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year." This is the first time that an official FOMC document sets out the timetable for normalising the balance sheet. Yet how it will happen is obviously undecided: a total or partial end to reinvestments? The end of reinvestments for MBS, for US Treasuries, or both? What will the objective allocation be for the balance sheet? And should the plan be to resume reinvesting in certain cases? The minutes show that the subject will be deliberated in the next FOMC meetings and that progress will be shared with the public as soon as possible.

It’s worth mentioning that according to the "Policy Normalisation Principles and Plans," eventually, the Fed will hold only those securities that it needs to implement its monetary policy effectively, and will hold mostly Treasury bills. This means that the goal is not to hold any more MBS, to hold slightly fewer Treasury notes & bonds, and also that the Fed could reinvest long-maturity Treasuries in T-bills.

FOMC members already agree that the balance sheet's normalisation must follow a simple and predictable rule, and that this rule must be shared with the markets well before it is carried out in fact. The markets’ reaction has been muted. Indeed, it is unlikely that the Fed would surprise the markets by a sudden reduction of the balance sheet.

Risky assets have enjoyed a relatively favourable environment since Trump's election. Valuations have been supported by the assumption of a better economic outlook and, especially, growth in profits, thanks to the measures taken by the new US administration. Investors have high expectations of tax reform.

• At the same time, the US economy has enjoyed extremely accommodating financing conditions. Yields remain low. Janet Yellen has already said that the fed funds increase cycle would only accelerate if there were significant fiscal stimulus measures.
• US risky asset valuations are tighter and tighter. The FOMC minutes show that its members had a discussion on the implications of vigorous equity prices, with some saying that prices were "rather high" compared to standard valuation measures. We're getting the same reading on the High Yield corporate bond market.

Investors are compensated less and less for the default risk. In recent years, of course, businesses have raised record amounts on the financial markets to fund share buybacks and mergers & acquisitions. The (historically) very high leverage makes US businesses very sensitive to weak profits or tighter financing conditions. As a consequence, flows can be very large: stock and HY funds registered important outflows over the last weeks.