The Daily Update - The Fed's Balancing Act

With the Fed widely expected to raise interest rates by a further 25 basis points at the end of its two day meeting on Wednesday, it might be tempting to think of it as a non-event. However, as we have been highlighting for at least the past year, it’s not just interest rates that matter, the size of the Fed’s balance sheet is also an important factor. Whether we get much clarity on this aspect from this meeting remains to be seen but it is something we will be watching closely; here’s why.

Quantitative easing is achieved by acquiring bonds whilst at the same time supplying the market with cash. This results in an increase in the Fed's balance sheet which ballooned from around USD 900bn in 2008 reaching a peak of around USD 4.5tn. The reversal of QE, quantitative tightening or QT sends that process into reverse but rather than the Fed selling bonds it instead has allowed some of the bonds to mature.

In the same way that QE is a decision to supply the market with a ‘quantity’ of liquidity rather than targeting a specific interest rate, QT is effectively the same decision only in reverse. So, whilst it is quite easy to provide more liquidity when rates are at zero, setting a target for Fed Funds whilst at the same time reducing the balance sheet is much more challenging. Consequently, one of the debates amongst Fed members is the management and size of the balance sheet itself.

In an interesting article back in February, Joseph Lavorgna, chief Americas economist at Natixis, writing for CNBC proposed that the Fed cap interest rates at 2% and then use the size of the balance sheet to manage the liquidity supplied to the market depending on economic conditions. This highlights the choice between setting an interest rate or altering the balance sheet.

Of course the reverse is also possible, fixing the balance sheet and then allowing rates to fluctuate. According to a Fed study, QE reduced long-term interest rates by 120 basis points and so if the balance sheet is not fully reversed then long term rates will remain structurally lower than before. So any hint that the eventual size of the Fed’s balance sheet might be much higher than some people had previously assumed, would be taken as a very positive signal for holders of Treasuries and investment grade bonds.

Please read this important information before proceeding. It contains legal and regulatory notices relevant to the information on this site.

This website provides information about Stratton Street Capital LLP ("Stratton Street"). Stratton Street is authorised and regulated by the UK's Financial Conduct Authority. The content of this website has been prepared by Stratton Street from its records and is believed to be accurate but we do not accept any liability or responsibility in respect of the information of any views expressed herein. The information, material and content provided in the pages of this website may be changed at any time by us. Information on this website may be out of date and may not be updated or removed.

The website is provided for the main purpose of providing generic information on Stratton Street and on our investment philosophy for the use of financial professionals in the United Kingdom that qualify as Professional Clients or Eligible Counterparties under the rules of the United Kingdom Financial Conduct Authority (the "FCA"). The information in this website is not intended for the use of and should not be relied on by any person who would qualify as a Retail Client. Products and services referred to on this website are offered only at times when, and in jurisdictions where, they may be lawfully offered. The information on this website is not directed to any person in the United States. The provision of the information on this website does not constitute an offer to purchase securities to any person in the United States (other than a professional fiduciary acting for the account of a non-U.S person) or to any U.S. person as such term is defined under the Securities Act of 1933, as amended.

The website is not intended to offer investors the opportunity to invest in any Alternative Investment Fund ("AIF") product. The AIFs managed by Stratton Street are not being marketed in the European Economic Area ("EEA") and any eligible potential investor from the EEA who wishes to obtain information on the AIFs will only be provided with materials upon receipt by Stratton Street of an appropriate reverse solicitation request in accordance with the requirements of the EU Alternative Investment Fund Managers Directive ("AIFMD") and national law in their home jurisdiction. By proceeding you confirm that you are not accessing this website in the context of a potential investment by an EEA investor in the AIFs managed by Stratton Street and that you have read, understood and agree to these terms.

No information contained in this website should be deemed to constitute the provision of financial, investment or other professional advice in any way. The website should not be relied upon as including sufficient information to support any investment decision. If you are in doubt as to the appropriate course of action we recommend that you consult your own independent financial adviser, stockbroker, solicitor, accountant or other professional adviser. Past performance is not necessarily a guide to the future. The value of investments and the income from them may go down as well as up. An application for any investment or service referred to on this site may only be made on the basis of the offer document, key features, prospectus or other applicable terms relating to the specific investment or service.

Where we provide hypertext links to other locations on the Internet, we do so for information purposes only. We are not responsible for the content of any other websites or pages linked to or linking to this website. We have not verified the content of any such websites. Such websites may contain products and services that are not authorised in your jurisdiction. Following links to any other websites or pages shall be at your own risk and we shall not be responsible or liable for any damages or in other way in connection with linking.

By using this site, you should be aware that we may disclose any information that we hold about you to any regulatory authority to which we are subject, or to any person legally empowered to require such information.

This website uses cookies to improve user experience, by clicking the "I Accept" button below means you consent to the use of cookies on our website.