The consequences of shrinking the Fed’s balance sheet

The Federal Reserve is now actively considering its strategy for the “normalisation” of its balance sheet, which it has indicated will start before the end of the calendar year. The key question is whether the shrinkage of the balance sheet, which amounts to the reversal of quantitative easing, will remove the underpinnings from the US bond market and global risk assets. We think there are three good reasons for believing that the effects of balance sheet normalisation on the bond market will be fairly muted: first, the balance sheet will not return fully to its 2008 starting point, so the scale of the market impact will be much less than the original impact of QE; second, some of the effects of future balance sheet normalisation may already be in the market; and, third, the Fed stands ready to offset any bearish impact from the balance sheet by easing the intended path for short rate increases if necessary. For these reasons, we think that, with effective communication, the Fed can avoid a repeat of the 2013 taper tantrum when it announces its balance sheet strategy in coming months.