I understand the problem about reducing the FED balance sheet and raising rates at the same time.

The impact on liquidity is however less intuitive to me. While the effect of interest rate hikes is clearer, the effect of a Balance Sheet reduction is less so.

Am I wrong to assume that what technically happens when the FED reduces i.e. sell bonds is that the private sector, through the banking system, receives these bonds? In exchange banks reduce the account balance that they hold at FED.

If banks get Treasuries in their book, they also receive more interest income (coupons) that goes into the system. This money was blocked in the book of the FED until then.

Why is this necessary bad?

Eoin Treacy's view

Thanks for this question which I’m sure others have an interest in. Since the financial crisis banks have been paid interest on the excess reserves, they hold at the Fed. Against an uncertain environment in the real world they therefore had an incentive to park vast sums at the Fed. In return they received interest income on that money in line with the Fed’s Funds rate. 

In June the Fed introduced a new regime where interest on excess reserves is paid about 10 basis points less than the Fed Funds Rate. This was aimed at making it less attractive to deposit funds with the central bank but it also reduces the relative interest income banks receive.

Additionally, if banks cannot get risk free money from the central bank they need to go to the market and buy something that had a similar return. However, anything that does not come as a guarantee from the central bank is necessarily riskier. That increases their relative risk premia which means they have to reduce liquidity in other areas to rebalance the volatility or relative risk premia metrics.

It’s taken a few months for the market to fully understand this change but it represents a significant headwind for the banking sector. As liquidity providers banks should do well in a bull market and the fact that the sector is trending down, globally, is not good news.

The Goldman Sachs Financial Conditions Index has been trending higher all year which signals tighter financial conditions and is in sharp contrast to the looser conditions that prevailed globally for all of 2017.