The Federal Reserve's Balance Sheet

Topics: The Federal Reserve, Mortgage-Backed Securities, Treasury Bills, Treasury Bonds, Agency Securities, Yield to Maturity, Duration

What Have We Here?

Ever wonder what the Fed has on its ($9 trillion) balance sheet? Curious as to what and when they're going to sell? Wondering if their returns look as bad as yours?

Team, candidly, I outdid myself on this one. I downloaded the whole Fed's balance sheet (30,000+ positions) and pulled in some live data from Refinitiv's handy API to give us some info as to how Papa Powell's P&L's been looking. Reach out to me if you want the live excel file w/ the integrated API.

Big Picture, High-Level Overview

The Federal Reserve's most recent cycle of quantitative easing (QE) involved purchases of Treasury Bonds, Residential Mortgage-Backed Securities (RMBC), Commerical Mortgage-Backed Securities (CMBS), and corporate bonds (and eligible fixed income ETFs), as well as direct lending to corporations.

Now, the Fed has "pivoted" to quantitative tightening (QT), as the Fed "intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves." 

The total amount of net QE from Q1 - Q3 of 2020 (when most of the QE happened) was $2.88T; this consisted of $2.1T in Treasury purchases and $1.1T in RMBS purchases. The net purchases of treasuries and RMBS are, in fact, larger than the net amount of QE over this period (you're very perceptive). It appears that the Fed reduced the size of other assets to support their purchases of treasuries and RMBS (lmk if you hear what it was - my guess is that those were agency securities, FRN, TIPS, or something else).

Oh, BTW, on the Fed's balance sheet, all securities are recorded at par; this is because the Fed is (currently) not expecting to sell these assets before they mature, meaning that they will receive the full par value of the security upon maturity of the bond. For more on bond pricing, here's an article from PIMCO.

Profit? What Profit?

Since Q3 2020, let's just say that interest rates haven't been what they once were. For example, Treasury securities the Fed purchased from Q1-Q3 of 2020 that are still on their books are down ~18%. Yikers. Thanks to a large upward move in interest rates, as well as an average maturity of 7 years, 92.4% of the Fed Treasury bonds are now trading at a discount to par (relative to 11% when they originally purchased those assets). Currently, they have $1.125T in unrealized losses. Good thing you only take a loss when you sell... Right?

All excess profits the Fed makes are returned to the U.S. Treasury in the form of Earnings Remittances. For the 9-months ended 9/30/2022, the Fed sent the U.S. Treasury $73.4B (they sent $107.4B to the Treasury during 2021); this amount can be used to fund government agencies, federal projects, and other government spending. However, as the Federal Funds rate has continued to rise, payments on the Fed's liabilities (reverse repos and deposits) have risen to the point where the Fed is currently operating in the red. No profits mean that the Treasury won't see its typically hefty payday; in fact, the Fed doesn't expect to turn a profit for a hot minute (a couple of years).

The Fed's operating losses have ballooned to ~$16B over the last few months; before the Fed can make payments to the Treasury again, they must first pay down this accumulated loss figure. Based on an analysis performed by the Fed, they believe the amount of accumulated losses could grow to as much as $180B. Some believe this doesn't matter, while others would postulate that it reduces the Fed's independence and ability to implement monetary policy. I'd side with the latter, adding that Fed losses will likely put additional pressure on the Federal government in financing government agency budgets and other spending.

Cool, The Fed Sounds Like It's Tight(ening)

Instead of selling securities outright, the Fed is reducing its balance sheet by letting securities mature and not reinvesting the proceeds. Specifically, the Fed will no longer reinvest proceeds up to $60B in Treasuries and $35B in Agency MBS per month (increasing from $30B and $17.5B before September, respectively). This is similar to what the Fed did during the last cycle of Quantitative Tightening. Below is a breakdown of the maturity distributions for assets on the Fed's Balance Sheet:

Here are some pretty charts I made with maturity distributions for each security (data is from 12/15/2022 bc it took me a sec to pull it all together):

The Fed has reduced the amount of its Treasury securities by ~$250B, relative to MBS being reduced by ~$75B.

Cooool, So What Difference Does It Make?

As shown in the charts above, T-Bonds represent the majority of maturing securities, indicating that these securities will be the first and fastest to roll off the balance sheet (as we've seen with the outsized decrease in Treasury securities up to this point). With reduced reinvestments and decreasing support by the Fed, given the same demand for treasuries (supply and demand), yields could rise. Heightened Treasury market volatility (Figure 1.3) paired with lower Treasury market depth (Figure 1.4) could amplify the effects of QT. Considering there is $23.7T of Treasury securities outstanding, the Fed controls a material portion of total assets outstanding.

From my observations of Treasury Yields, I have been V surprised at how volatile they've been. This, of course, relates to investors attempting to predict the terminal Fed Funds rate. If, however, you are one that likes to invest with the Fed (instead of against the Fed), then I'd caution you to perhaps take a breather for a sec (slow purchases, shift investment strategy, or adjust portfolio weights), especially when it comes to longer-duration Treasuries.

In Conclusion...

1. The Fed has supported the economy for a hot minute with mucho dineros, but now the Fed's playing their draw 4 wild uno card (Increasing Fed Funds + reducing balance sheet) because apparently a $9T balance sheet, near-zero interest rates, and infinite quantitative easing are unsustainable. Who knew...

2. The Fed's been making bank (haha) and giving it to the U.S. Treasury, but now their P&L is starting to turn from green to red, because their portfolio isn't the only one taking a big fat L this year.

3. As the Fed unwinds its balance sheet, Treasury securities are likely to receive the largest reduction in support, as the Fed has many soon-to-be-maturing Treasury bonds on its book (though they will cap the amount they don't reinvest at $60B/month). Plz beware of increasing treasury yields. This is not to say that other yields won't rise too, as they may.

4. Treasury bond markets have lower than usual market depth and higher than usual volatility (perhaps a bit of a feedback loop), which could amplify the impacts of quantitative tightening.

If you'd like me to expound on any of this, just holla at me here.

Stay intelligent, investors.