Federal Reserve To Shrink Balance Sheet This Fast; Nasdaq Leads Stocks Lower

The Federal Reserve revealed that it will shrink its balance sheet starting in May, which led the Nasdaq to lower stocks.

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May 14, 2023 • 2 min read

Minutes from the meeting of March 15-16 indicate that the Federal Reserve is on track to shrink its balance sheet by $95 billion each month. This pace will be reached over a period of three months. The Nasdaq continued to fall after the Fed minutes were released, as the growth stocks suffered from the surge in long-term Treasury rates.

The Fed will instead set monthly limits for shrinking its debt portfolio as bonds mature rather than investing the principal. In the minutes, it was stated that "participants were generally in agreement that monthly caps would be about $60 billion for Treasury Securities and about $35 billion agency MBSs (mortgage-backed securities)."

The minutes stated that these caps could be gradually implemented over a three-month period, or possibly a little longer.

The $95 billion cap per month could be implemented as early as July, with a policy announcement due to take place at the meeting on May 3-4.

Federal Reserve announced that its short-term Treasury Bills would be redeemed to meet monthly cap reductions. MBS redemptions could fall short of the monthly cap due to prepayments such as those made when someone refinances.

After the balance-sheet runoff has "well begun", policymakers will be considering selling off all of the Fed's holdings in mortgages.

Wall Street was caught off guard on Tuesday by the extent to which Fed Governor Ben Bernanke sees tightening balance sheets as part of an anti-inflation one-two-punch. Fed Gov. Lael Biden, the nominee of President Joe Biden to be Fed vice-chair and one of the more dovish members of policy committee, said it was "of paramount importance" to bring inflation down.

Brainard stated that the committee would continue to tighten monetary policy in a methodical manner through a series interest rate increases, and begin to reduce the balance at a rapid speed as soon as the May meeting.

Her comments sparked an immediate stock market decline on Tuesday. The Nasdaq fell 2.3% while the S&P 500 dropped 1.3% and Dow Jones lost 0.8%. The stock market sold off as the 10-year Treasury rate shot up by 14 basis points, reaching a three-year high of 2.56%. It then went even higher on Wednesday to reach around 2.61%.

The Nasdaq fell 2.2% on Wednesday. The Dow Jones fell 0.4% and the S&P lost 1%.

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The Federal Reserve bought about $4.5 trillion of Treasuries, government-backed mortgages and other securities from the beginning of the pandemic until March. This roughly doubled the Fed’s balance sheet.

Quantitative easing (also known as asset purchases) allows the Fed to relax monetary policy, even when its benchmark rate is zero. The Fed can lower interest rates by purchasing these safe assets, which encourages risk taking in multiple ways. This lowers the return from safe assets. This boosts the valuation of growth stocks by increasing future cash flows' present value based on lower 10-year Treasury rates.

Finaly, Federal Reserve purchases boost liquidity by releasing funds previously parked in Treasuries or mortgage securities.

All of these impacts will now begin to reverse, creating a headwind on stocks and in particular the growth stocks which heavily populate Nasdaq.