The Incredible (Shrinking) FED Balance Sheet


James Bernard, CFA, Managing Director, Fixed Income

Historically, securities markets have faced many extreme valuation situations caused by numerous factors not limited to supply-demand imbalances, strong vs. weak economies and earnings environments. In recent years (post 2008) we have experienced a prolonged period of extremely low interest rates both domestically and in many developed markets around the world. A significant contributor to lower rates, in addition to low inflation and relatively weak economies, has been added demand primarily for government bonds as a result of the expansion of the FED balance sheet.

Starting in early 2009 and continuing over three separate quantitative easing programs, the U.S. Federal Reserve balance sheet expanded from just under $800 billion to over $4.6 trillion, where it remains today. The majority of this expansion occurred as the FED purchased U.S. Treasury Notes and government backed mortgage backed securities in the new issue and secondary markets. The significant additional demand for these securities contributed to driving rates down to historic lows and keeping them there.

Recently the FED has announced their intention and desire to reduce the size of their large balance sheet closer to the low $2 trillion range. This is a reduction of approximately $2.5 trillion, which they indicate they would like to see happen over the next 4-5 years. Such a reduction in a central bank balance sheet has never occurred before as a balance sheet had never expanded like that in the past. All other economic factors being equal, conventional wisdom would indicate that when you add massive funds to a securities market in a finite period of time, prices will increase. Obviously, this price impact occurred as noted previously, therefore one may assume when this process is reversed prices will fall.

Even though the FED has tried to make this pending reduction of the balance sheet as transparent and well signaled as possible during their periodic speeches, comments, and in the FED minutes released to the public, it appears logical that either higher interest rates or wider credit spreads or both will occur sometime during the FED reduction program. As an indication of just how extreme some valuations currently are, the high yield euro 1-5-year corporate bond index currently yields 1.46%, with an average quality rating of BB- and an average maturity of 2.26 years as compared to a 2.25-year U.S. Treasury Note currently yielding 1.33%. In other words, investors are receiving very minimal additional yield for investing in non-investment grade, highly leveraged euro corporate bonds when compared to a similar U.S. Treasury Note. Historically the gap between the yield on a U.S. Treasury Note and the yield of a BB corporate bond is at least 500 basis points or 5%. This implies that today, BB corporate bonds should be yielding closer to 6.33% rather than 1.46%.

Our conclusion is that while there are other factors besides supply-demand imbalances that can influence valuations in securities markets, reversing the current supply-demand imbalance should likely produce either higher interest rates or wider credit spreads or both in coming years. Other events such as changes in economic growth or changes in inflation rates can also influence future levels of interest rates, but the effect of a balance sheet reduction bears watching closely.

Jim Bernard, CFA, is the Managing Director, Fixed Income at Ancora Advisors LLC a SEC Registered Investment Advisor.

The mention of specific securities, types of securities and/or investment strategies in this newsletter should not be considered as an offer to sell or a solicitation to purchase any specific securities or to implement an investment strategy. Please consult with an Ancora Investment Professional on how the purchase or sale of specific securities can be implemented to meet your particular investment objectives, goals, and risk tolerances. Past performance of these types of investments is not indicative of future results and does not guarantee dividends/interest will be paid or paid at the same rate in the future. The data presented has been obtained from sources that are believed to be accurate and credible. Ancora Advisors makes no guarantee to the complete accuracy of this information. The indexes discussed are market performance indices and are not available for purchase. If you were to purchase the securities that make up these indices, your returns would be lower once fees and/or commissions are deducted. Past performance of these indices is not indicative of future results of the securities contained in these indices.

Ancora Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management, and practices are contained in its “Firm Brochure” Form ADV, Part 2a. A copy of this form may be received by contacting the company at: 6060 Parkland Blvd, Suite 200, Cleveland, Ohio 44124, Phone: 216-825-4000, or by visiting our website

View All >