By Patti Domm, CNBC
Interest rates may be going up even faster than you think.
That's because the Federal Reserve, in the minutes from its last meeting, announced that it would begin to shrink its balance sheet, ending some of the extreme measures it took to save the economy during the financial crisis.
The Fed balance sheet grew from about $1 trillion before the crisis to $4.5 trillion currently, as the central bank purchased Treasurys and mortgages to help the economy and keep interest rates low. The Fed carried out such "quantitative easing" even as it held interest rates at zero for years.
After it ended those "QE" programs, the Fed maintained one feature of the policy — it replaced the securities in its portfolio as they matured by buying more. That is the policy it may now end.
Since late 2015, the Fed has raised the federal funds target rate range three times, and it plans a fairly gradual and steady pace of interest rate hikes, with two more this year. In the minutes, it revealed that members would like to start shrinking the balance sheet later in 2017 — meaning that is when it may stop buying all the securities that mature.
That is several months sooner than some market participants had expected, and it could have the net effect of causing higher interest rates for mortgages and other types of loans.
"If you get good data, and things are going well, and we get some tax plan, then rates will go up faster than they otherwise ordinarily would have, with the reduction in the balance sheet," said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management.
Caron said when the Fed stops replacing securities, it in effect is removing some of its easy money policy.
"That should make rates go up. That's putting supply back into the market, effectively reducing the stock of securities. There were always two ways to think about the Fed's quantitative easing: One was the flow effect, the action of buying the securities, and the other was the securities the Fed held onto and took out of the market — the stock of securities they held," said Caron.
The Fed, in the minutes, was not clear how it would reduce its balance sheet or by how much, but New York Fed President William Dudley last week suggested the central bank could raise rates a couple more times and then pause, to make some adjustment to the balance sheet before resuming rate increases again.
Mark Cabana, head of U.S. short-rate strategy at Bank of America Merrill Lynch, said the Fed could raise the fed funds target range two more times this year, possibly in June and September, and then announce measures at its December meeting to reduce the balance sheet.
Shrinking the balance sheet could affect interest rates in several ways, he said. First, if the Fed no longer buys mortgage securities, then mortgage rates could rise because it removes one big, steady buyer from the market. Secondly, Treasury rates could rise if it no longer replaces those securities, and that could affect the rates of home mortgages and other loans.
Cabana said the amount of Treasurys alone that would roll down in 2017 amounts to about $195 billion. The fact that the Fed goes into the market and buys securities to replace those that roll down has helped keep interest rates low, because it has been a continuous buyer. In 2018, even more of those Treasurys would roll down — $422 billion worth, and in 2019, another $346 billion would mature.
If the Fed were to no longer replace the securities, the Treasury would have to raise cash to pay the Fed back for the maturing securities. That could come in the form of increased Treasury issuance.
"It could be bills or concentrated at the front end of the curve. I've been thinking it would be shorter-dated bills. It's the cheapest and fastest way for Treasury to raise additional cash," he said.
Bob Miller, lead portfolio manager of the BlackRock Total Return Fund, said he expects a lengthy research effort by the Fed before it reduces reinvestment in a very cautious and deliberate way.
"We think it's quite plausible that the first balance sheet adjustment may come as early as the fourth quarter of 2017, but there's also the possibility that the event is deferred to sometime in the first quarter of 2018, if the committee struggles to reach a decision on the policy," he wrote.
Miller noted that the composition of the Fed board could change, and that may affect the decision-making process.
"Additionally, Trump administration appointments to the Board of Governors could also impact the outcomes of rate normalization and balance sheet adjustment, so we'll be watching this nomination process very carefully," he wrote.
Caron said the fact that the Fed is talking about acting on the balance sheet this year will make it one of the final acts of Fed Chair Janet Yellen, whose term ends in January.
"If they're talking about doing it this year, then Janet Yellen is saying under the Janet Yellen Fed, they are starting the balance sheet winddown. They are not kicking the can to the next person," he said. "That's kind of setting the course for the next Fed chairperson to handle it."
Courtesy of CNBC