The Fed may need to slow down the balance sheet reduction process to avoid a sharp flattening of the yield curve

The Fed has strongly hinted that it will start raising interest rates in March, and soon thereafter begin reducing its holdings of U.S. Treasuries and mortgage-backed bonds (MBS) on its balance sheet. But industry research rate strategists Ira Jersey and Angelo Manolatos argue that the Fed may need to shrink its balance sheet more slowly than the market currently expects to avoid a rapid flattening of the yield curve.

They believe that as early as May, the Fed will gradually achieve the purpose of reducing its balance sheet by no longer reinvesting the principal of the US Treasury bonds and MBS due. Strategists believe that doing so could allow the Fed to replace potential rate hikes with balance sheet reductions, avoiding a faster flattening of the yield curve than markets expect.

The fed started very slowly the last time it began shrinking its balance sheet, reducing only $6 billion in U.S. Treasuries and $4 billion in MBS per month. After a year, the monthly reduction reached $30 billion and $20 billion, respectively. Jersey and Manolatos believe the Fed's balance sheet reduction will start much faster, reaching $90-100 billion at the beginning, and the balance sheet will quickly become smaller.

This article originated from the financial world