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Author: Blu Putnam, CME Group

AT A GLANCE:
· Purchasing $25-$30 billion per week in Treasuries and mortgage-backed securities means that the Fed balance sheet will start to grow again
· We expect the Fed to expand U.S. Treasury purchases to cushion the impact of new fiscal stimulus and anticipated Treasury issuance

The Federal Reserve (Fed) has shifted its approach to the pandemic of 2020 in some important ways throughout the year. Initially, from late February through early June, the Fed purchased a wide variety of assets and provided loans to several parts of the financial system, expanding its balance sheet from about $4 trillion to $7 trillion. Since mid-June, the Fed has increasingly focused on the purchase of coupon-paying Treasury securities and mortgage-backed securities, while at the same time dramatically reducing loans to the financial system and central bank FX swap lines.

This switch from a broad-based approach to a narrow focus on Treasuries and mortgages meant that the Fed went through a period of several months (July-September) of no growth in its balance sheet.

Going forward, the commitment to continue purchasing coupon-paying Treasuries and mortgage-backed securities at a rate of about $25-$30 billion per week, means that the balance sheet will start to grow again.

We estimate the Fed will end 2020 with a balance sheet of about $7.4 trillion. Moreover, we expect the Fed to be very active in 2021 with expanded purchases of U.S. Treasury securities to cushion the impact on the markets of subsequent rounds of fiscal stimulus and massive Treasury issuance that is expected post-election. We could see the Fed’s balance sheet expand to between $8.5 trillion and $10 trillion by the end of 2021 depending on the size of the U.S. budget deficit.

While the Fed has not explicitly stated that it has a yield-curve control policy, the central bank’s actions to-date suggest that they are comfortable with the 10-year Treasury trading in a yield range of about 0.6% to 0.9%. That is, if yields go below this range, the Fed would view that as a very negative signal for economic confidence. If yields went above this range, the Fed would take the view that rising yields might impair the pace to the economic rebound. We note, though, that we are reading between the lines of Fed statements and guidance, and that the Fed is data dependent, so when data trends change, the Fed might change its approach.

The Fed has also changed its guidance concerning future inflation by making it clear that if the U.S. inflation rate starts to rise above the 2% target, they will allow substantial over-shooting before considering raising rates. Please note that changing targets and guidance does not necessarily have any impact on the process of inflation or inflation expectations. Market participants are firmly grounded in the view that inflation is not a current concern, otherwise there would not be $17 trillion of negative-yield debt around the globe. Also, expectations from federal funds futures suggest a consensus that the Fed will keep rates near zero for several years.

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