Last June's announcement that the U.S. central bank would begin unwinding the Fed's balance sheet sent analysts scrambling. The "Great Unwinding" signals the end of an unprecedented era for the U.S. — and for central banks around the world. The velocity at which global financial markets began to buckle during the financial crisis of 2007–2008 challenged the role of central banking and set off a period of unconventional policy. As crisis central banking looks to be coming to an end, its impact will likely be felt most in the sector at the center of this shift: the banking industry.
Looking back: The global response to the financial crisis
During the Great Recession of 2007, global economies were threatened with a short-term debt market, propped up by years of easy credit, that was rapidly becoming illiquid. So, central banks across the globe embarked on a program comprising huge rate cuts and historically unique purchases of deteriorating assets. The U.K.'s program, which eventually shaped the guiding principles for the pan-European plan, included liquidity support, interbank lending guarantees and recapitalization of distressed banks.
In Asia, China coordinated its monetary policy for the first time to align with the world's central banks. Cutting its interest rates, China also eased its reserve requirements for bank deposits. India and Singapore followed in similar suit. The South Korean central bank moved to inject banks with $30 billion of new liquidity, plus loan guarantees totaling $100 billion. For its part, the Bank of Japan injected trillions of yen to prop up interbank borrowing, at one point making available 1 trillion yen a day for a 30-day period.
Multiple central banks around the world also embarked on quantitative easing (QE), printing money to finance massive purchasing of illiquid, mostly government debt. In 2001, the Bank of Japan first tried QE when it promised to buy 400 billion yen of government bonds a month in an effort to boost the level of reserves to 5 trillion yen, as The Economist reports. Europe also adopted QE, as it cut rates and focused first on propping up specific member states in crisis. In 2009, the European Central Bank (ECB) began buying corporate debt and expanded that activity in 2015 to include government, agency, and more corporate bonds. In March of 2018, the ECB announced that its government bond buying program, which reached a peak of 60 billion euros per month, will begin tapering to just half that amount by the end of the year.
Ten years removed from the financial crisis that spurred the adoption of these somewhat unorthodox monetary policies, central banks now find themselves in an entirely different global economic climate — a much brighter one. As a result, monetary policies are shifting around the world with central banks considering shrinking their balance sheets, rather than growing them.
The 'Great Unwinding': Spotlight on the Federal Reserve
If quantitative easing was unprecedented in size and scale, the unwinding of it is equally without precedent. Nowhere is that more true than in the U.S. where in 2007, the Federal Reserve faced the worst financial crisis of a generation. So, the Fed began purchasing government and mortgage-backed bonds. The Fed's balance sheet, which entered the year at $900 billion, bloated to over $4 trillion by the end of the crisis.
In June 2017, the Federal Reserve announced that it would finally begin unwinding its balance sheet. The Fed isn't auctioning off its portfolio; it will allow bonds to "roll off," meaning that instead of reinvesting the proceeds of bonds as they mature, the Fed will pocket $10 billion worth of maturing bonds monthly, according to Bloomberg. Assuming the market can handle the unwinding of its balance sheet, the Fed plans to ramp up this process to about $60 billion per month. Although the Fed hasn't communicated exactly how much of its balance sheet it would unwind, it's safe to say it will take years to normalize its holdings.
The impact of unwinding the Fed's balance sheet
While the effects of running down the balance sheet aren't known yet, it's sensible that the size of its impact will be smaller than quantitative easing itself, given how slowly the Fed plans to shrink its holdings, says The Financial Times. There will be no direct sales of bonds into the open market. The Fed also plans to use the funds rate to counteract any adverse effects.
But there will be longer, more profound changes in the economy. According to Bloomberg, the end of the "cheap leverage and low volatility forever" era ushers in higher volatility and higher bond yields, effectively making it harder to employ leverage. Unwinding this cheap leverage may add to volatility.
The Great Unwinding may also impact corporate bonds, as Bloomberg reports. Though the Fed didn't buy corporate debt, QE pushed yields lower on debt, making it cheaper for companies to borrow. This opened the floodgates for high-grade corporate debt, as quality companies issued over $1 trillion in 2017, breaking the previous year's record. Some of this money went into share buybacks, pushing the U.S. stock market to all-time highs. As more retail exchange traded products track the corporate bond market, investors may bail when yields rise and prices fall.
Economics and politics
There may be another effect of the unwinding of balance sheets. A recent study reported by Reuters pegged the likelihood of the Fed booking a future loss on its bond holdings at 30 percent. That probability drops to 5 percent if it sheds $1.3 trillion of its reserve balances. The authors of the study, five central bank economists and an independent professor, believe that shrinking the Fed's portfolio will help to insulate the institution against any political and populist backlash that could result from investment losses.
What happens to the U.S. banking industry
But the biggest impact of all may be felt by the banking industry. Banking stands to benefit from a steepening yield curve, which typically improves bank profitability. However, banks have seen massive benefits from the newly created money flooding the market as a result of QE. Deposit levels at U.S. banks have soared by two-thirds since 2009, adding an estimated $1.6 to $2.5 trillion in deposits to the banking system, according to The Financial Times.
With the Fed reversing course, hundreds of billions of dollars of deposits are expected to exit the system. With a declining deposit base, competition over existing deposits is picking up. With near-zero interest rates, customers didn't have a real reason to move their accounts. Banks are now facing the prospect of a double-whammy of increased competition from incumbents, as well as from upstart online banks that are vying hard for customer assets.
The unwinding of the Fed's balance sheet is bound to have far-reaching consequences. quantitative easing's injection of cheap money into the global financial system had a lot of knock-on effects that contributed to record high-grade debt issuance and what feels like a never-ending bull market in stocks. Now, as the central banks around the world attempt to shrink themselves, it's not entirely clear what the future holds. The only thing that seems certain is that interest rates and volatility will rise. The banking industry is definitely taking note.
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