According to William Dudley, the president of the Federal Reserve bank of New York, we might see the Federal Reserve reducing the size of its balance sheet sooner rather than later. Whilst Dudley seemed to have been hinting at just letting the securities on the balance sheet mature and take the cash out of the market (rather than reinvesting the proceeds), this isn’t the only option on the table.

On the exact same day when Dudley discussed the size of the balance sheet of the Fed, the president of the St Louis Fed, Bullard, also launched his own idea. Rather than just slowly reducing the balance sheet of the central bank by not reinvesting the proceeds from securities which reach their maturity date, Bullard openly discussed the potential to just sell the assets.

Fed 1

Source: St Louis Fed

As you can see on the previous image, the total size of the Fed’s balance sheet is approximately 4.5 Trillion, and figuring out how to reduce it perhaps isn’t the worst idea to investigate. After all, by selling securities on the open market, the Fed will be taking more (easy and cheap) cash out of the market as well. So technically and theoretically, selling (hundreds of) billions in assets on the market could have a similar impact as a rate hike.

After all, selling debt securities will reduce the price of those securities and thus increase the yield to maturity. And this could immediately solve another problem the Fed has been facing.

According to Morningstar, the flattening yield curve is worrying investors, as the spread between the 10 year bonds and 2 year bonds has decreased to just over 1.1%. This could indicate that ‘either the economy is slowing down, or the riskier asset classes are overpriced’.

Fed 2

Source: St Louis Fed

This might very well be true. Due to the cheap money policy of the Federal Reserve and its European counterparts, it became extremely cheap for companies to issue debt. For most robust and strong companies this was a real blessing as the lower interest rates allowed them to cut the interest expenses, which boosted the bottom lines of these companies.

Unfortunately the ultra-low yields (with some companies being able to issue debt with YTM’s of close to 0%) pushed some investors into a ‘yield-chasing’ mode, buying whatever they could to increase the average interest income in their portfolios. This blind yield-chasing has led to some very undesirable results as now even the companies without investment-grade debt quality were able to secure funding.

Fed 3

Source: Bloomberg

And this puts the entire economic system at risk again, as reducing the liquidity in the markets will have  a double undesirable effect. First of all, due to the higher interest rates and higher spread, the demand for sub-investment grade securities will decrease (as the yield-chasing appetite will be reduced); and this could (and very likely will) have a negative impact on the survival chances of those companies. And of course, should they go belly-up, the debt holders very likely won’t recoup their original investment, creating a new round of investment losses and a further contraction in available liquidity as the risk appetite will undoubtedly decrease as well.

Whatever the Federal Reserve wants to do next, it should think long and hard before acting as it won’t be easy to repair the damage…

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