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Given the runoff rates in 2018, the situation may change in 2019, as the balance sheet reduction could accelerate from here as the maximum runoff caps are phased in. Will the Fed take the opposite approach of “slower rate hikes and faster balance sheet unwinding” this year? While the amount of maturing Treasury securities can be projected with certainty, the principal pay-downs of MBS are model-based estimates due to the embedded prepayment option, driven by variables like the path of interest rates, housing price movements, mortgage credit conditions, and employment situations of homeowners, etc. Based on the maturity schedule, the Federal Reserve Bank of New York (see Chart 2) projected Treasury redemption could reach $262B—assuming normal maturity and subject to the caps—and the projected MBS reduction hovers around $163B; however, a 200 basis point downward rate shock to the mortgage rate could push MBS runoff to exceed $240B. So in its base scenario, we can get $425B reduction, a 23% increase from the $346B in 2018. We believe the increase in the speed of the Fed balance sheet runoff could have a significant impact on the market, especially the long-end of the Treasury curve, as most of the Fed’s holdings are long-dated. With almost all major central banks reversing quantitative easing—including the European Central Bank’s recent coda to its asset purchases—we could face more of a dollar liquidity shortage. These are just a few reasons why the Fed should consider taking it slow with regard to both forms of tightening; given Chairman Jay Powell’s recent comments on January 4, we think he and other Fed officials are finally open to reevaluating this pace.
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