Wells Capital Management

Market insights Short Duration Fixed Income

November 2017

The Fed’s balance sheet normalization plan

What is the Federal Reserve’s plan, and how may it impact investors?
Jeffrey L. Weaver, CFA Tammy Ho
Head of Money Funds and Short Duration Fixed Income Fixed Income Portfolio Analyst
Money Funds and Short Duration Fixed Income

A central bank’s role in the economy through Table 1 Quantitative easing phases timeline
quantitative easing (QE)
Since 2007, global central banks have employed an economic stimulus QE I Balance sheet composition change from solely Treasuries to Treasuries
measure known as quantitative easing (QE). When central banks and Agency MBS focus
undertake quantitative easing, they expand their balance sheets Nov. '08 - Mar. '10 Initially purchased $500B in MBS and $100B in agency
through security purchases. Looking at the central banks of the United (17 months) debt from Fannie Mae, Freddie Mac, and Federal Home
States, the Eurozone, Japan, and the United Kingdom, the combined Loan Banks; later expanded mortgage purchasing
program to purchase an additional $750B in MBS, $100B
balance sheet total is an unprecendented size of US$14.9 trillion due to in agency debt, and $300B in longer-term Treasuries
balance sheet expansion in recent years (Chart 1).
Total Purchases: $175 billion in agency debt (less than
previously announced $200B), $300B in Treasuries, and
Quantitative easing increases money supply in the banking system for $1.25 trillion in MBS
lenders and lowers interest rates for borrowers. In theory, this spurs QE II Treasury Large-Scale Asset Purchase Program
growth in business and consumer spending, and ultimately, economic
Nov. '10 - Jun. '11 Purchased $600B in longer-term Treasuries and
recovery. After quantitative easing stabilized the U.S. economy, the (8 months) reinvested QE1 principal payments of $167B
U.S. Federal Reserve (Fed) implemented a balance sheet normalization
Total Purchases: $767B in longer-term Treasuries
program to reduce the balance sheet to an optimal size.
Operation Twist: Extend from short-term into longer-term Treasuries

Chart 1 Central Bank balance sheet assets in USD Sep. '11 - Dec '12 Purchased longer-term Treasuries with maturities of 6 to
(16 months) 30 years and sold short-term Treasuries with maturities of
$16 3 years or less to extend the average maturity of holdings
Bank of Japan
$14 QE III Reducing pace of Treasury and Agency MBS purchases
Bank of England
$12 European Central Bank Sep. '12 - Oct. '14 Purchased mortgage-backed securities and long-
$4.7
(26 months) maturity Treasury securities, initially set at $40 billion
$10 U.S. Federal Reserve
$ in trillions

$0.7 in MBS per month and $45 billion for long-maturity

$8 Treasuries per month
$6 $5.1 Taper Tantrum (Dec. '13): Announcement that the
Fed would reduce the pace of purchases by $85B per
$4
month causing violent market reactions
$2 $4.4
Reinvestment Policy for maintaining size of the balance sheet
$0
Aug. '10 - Present Replaced maturing securities to maintain a constant
Sep-06

Sep-07

Sep-08

Sep-09

Sep-10

Sep-11

Sep-12

Sep-13

Sep-14

Sep-15

Sep-16

Sep-17

balance sheet size when no QE program is underway

Note: Exchange rate to U.S. dollars taken as mid-rate from Composite London (CMPL) for corresponding date.
Sources: Bloomberg September 2017, Bank of England.
Expansionary impact of QE on the Federal Reserve’s
balance sheet
In the wake of the 2007–2008 financial crisis, the Fed employed
quantitative easing in three phases (QE I, II, and III) through large-scale
purchases of Treasuries and agency mortgage-backed securities (MBS).
Prior to the financial crisis and quantitative easing, the Fed’s balance
sheet holdings were primarily in Treasuries with no agency MBS. How-
ever, the Fed initiated agency MBS purchases in an effort to support the
housing market, lower mortgage rates, and improve financial conditions.
Note: MBS refers to agency MBS from Fannie Mae and Freddie Mac. Sources: Board of Governors of the
Federal Reserve System, Federal Reserve Bank of New York.
During the six years between November 2008 and October 2014,
the Fed quadrupled the size of its balance sheet from less than $900
billion to roughly $4.5 trillion (purchases of $2 trillion in Treasuries and
$1.8 trillion in MBS). After quantitative easing ended in October 2014,
the Fed maintained the balance sheet at approximately $4.5 trillion
through reinvestment of principal proceeds from maturing securities.
The Fed’s path to normalizing the balance sheet
At the June 2017 FOMC meeting, the Fed announced balance sheet
normalization plan details to let maturing assets runoff rather than
reinvesting the principal proceeds. At the September 2017 FOMC meet-

|  1 |
Market insights | November 2017

Chart 2 Balance sheet expansion timeline

$5.0
As of 9/27/17 QE 1 QE 2 QE 3 $4.5 $4.4
$4.5  Balance sheet Nov ‘08- Nov ‘10- Sep ‘12-Oct ‘14
$4.0 assets: $4.4T Mar ’10 Jun ’11
 Treasuries: $2.5T
$3.5  MBS: $1.8T $3.0
$2.5
$ in trillions

$3.0
$2.4
$2.5 $2.2
$2.0
$1.5 $0.9
$1.0 $1.8

$0.5
$0.0
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Sources: Federal Reserve Bank of St. Louis, Federal Reserve Bank of New York.

ing, after indicating “[economic] recovery is on a strong track,” the Fed
announced the start-date of the normalization process in October 2017.
Starting in October 2017, the Fed only reinvests principal proceeds
exceeding the set monthly caps in Table 2, which start at $10 billion
per month and increase quarterly until the cap reaches $50 billion.
The initial $10 billion cap is separated into a $6 billion cap for Treasuries
and a $4 billion cap for agency securities (agency debentures and
MBS). Principal proceeds below the cap will be allowed to run off the
balance sheet.
The Treasury cap increases quarterly by $6 billion, while the agency
securities cap increases quarterly by $4 billion. By October 2018, the com-
bined maximum cap of $50 billion ($30 billion Treasuries and $20 billion
agency securities) will likely be in place for gradual balance sheet runoff.
Table 2 Statement regarding reinvestment in Treasury securities
and agency mortgage-backed securities
The schedule of monthly caps consistent with the Committee’s
September 20 decision and the June 2017 addendum is as follows:
Monthly caps on System Open Market Account (SOMA)
securities reductions
Treasury securities Agency Securities1
Oct - Dec 2017 $6B $4B
Jan - Mar 2018 $12B $8B
Apr - Jun 2018 $18B $12B
Jul - Sep 2018 $24B $16B
From Oct 20182 $30B $20B
1 Applies to combined principal payments of agency debt and agency MBS.
2 Once caps reach their maximum amounts, they will remain in effect until the Committee judges
that the Federal Reserve is holding no more securities than necessary to implement monetary policy
efficiently and effectively.
Source: Federal Reserve Bank of New York, as of September 20, 2017.
Projected balance sheet runoff
Balance sheet size
With a $4.5 trillion balance sheet as of September 2017, it is widely
expected that the Federal Reserve’s balance sheet normalization
process will take 4–6 years to reach a 2020–2023 target size of $2.5
trillion to $3.0 trillion. Chart 3 illustrates three potenial balance sheet
path scenarios based on the Fed’s projected long-run liabilities. In the
median scenario, the balance sheet normalizes to an estimated $2.9
trillion size in the fourth quarter of 2021. It is reasonably expected
that the Fed’s optimal balance sheet size will be larger than pre-crisis
levels of $900 billion. If economic conditions deteriorate, the Fed may
slow the pace of balance sheet reduction.
Treasury securities
Based on the Fed’s disclosed balance sheet holdings, the maturity profile
of Treasuries is known with a high degree of certainty. As Treasuries
mature, Treasury caps will likely be fully met mostly in mid-quarter
months from late 2018 to 2019, with remaining Treasury principal
proceeds over the cap reinvested. As shown in Chart 4, almost half of
the Fed’s $2.4 trillion total Treasury holdings mature between 2017 and
2020, with maturities peaking in 2018 and leveling off in later years.
Agency securities (Agency debentures and agency MBS)
While the maturity dates of agency debentures are known with a high
degree of certainty, the mortgage prepayment option in agency MBS
brings uncertainty to expected principal paydowns. Chart 5 illustrates
a projected paydown path based on MBS prepayment models. The
actual agency MBS paydowns will ultimately be determined by the path
of interest rates, housing prices, credit conditions, and the behavior of
the underlying mortgage borrowers.
Under current prepayment model assumptions, the median scenario
projects $115 billion agency MBS and around $2 billion agency
debentures to pay down in 2018, with $39 billion runoff and $78
billion reinvested. Based on the projected paydowns, monthly agency
MBS maturities will likely start falling below the cap in the second half
of 2018, with reinvestments tapering from 2019 onward. The model
assumes that as the Fed raises the target Federal Funds rate and pre-
vailing interest rates rise, principal paydown speeds will slow. Howev-
er, paydowns can speed up with downward shocks to mortgage rates,
triggering refinancing and mortgage prepayments.
Well-telegraphed news from the Federal Reserve, so
what is the impact on security yields?
With the Fed’s tapering of reinvestments, Treasury and MBS investors
will certainly feel the impact of increased Treasury and MBS supply in
the market. However, future yield increases are limited by the normal-
ization caps and the gradual nature of normalization, allowing only a

|  2 |
Market insights | November 2017

Chart 3 Projected SOMA Domestic Securities Chart 4 Projected SOMA Treasury Securities Chart 5 Projected SOMA Agency Debt and
Holdings: Alternative Liabilities Scenarios Maturity Profile MBS Principal Pay-Down Profile
Billions of U.S. dollars Billions of U.S. dollars Billions of U.S. dollars
4,500 80 35
4,000
70
30
3,500
60
3,000
50 25
2,500
40 15
2,000
30
1,500
10
1,000 20

500 10 5

2010 2012 2014 2016 2018 2020 2022 2024 2017 2018 2019 2020 2021 2017 2018 2019 2020 2021
Smaller liabilities Larger liabilities Redemptions Reinvestments Redemptions Reinvestments
Median Runoff Cap Runoff Cap
Source: Federal Reserve Bank of New York, as of July 2017. Source: Federal Reserve Bank of New York, as of July 2017. Source: Federal Reserve Bank of New York, as of July 2017.
Notes: Figures for 2010-16 (shaded area) are historical settled hold- Notes: Figures are monthly. Figures for January through May 2017 Note: Figures are monthly. Figures for January through May 2017 are
ings. Smaller and larger liabilities are based, respectively, on the are historical maturities. The maturity profile is associated with the historical pay-downs. The paydown profile is associated with the
25th percentile and 75th percentile responses to a question about median liabilities scenario. Projected figures are rounded. median liabilities scenario. Projection assumes primary mortgage
the size and composition of the Federal Reserve’s long-run balance rates that are 200 basis points lower than those assumed in the
sheet in the New York Fed’s June 2017 Surveys of Primary Dealers median projection scenario starting in Q4-2018. Projected figures
and Market Participants. Projected figures are rounded. are rounded.

maximum amount of Treasuries and MBS to run off in a given month. the Fed’s MBS purchases in half. This increased net supply will likely
Because the plan has been well-telegraphed by the Fed, investors and cause spreads to widen between 10 and 20 basis points in the first
the financial markets are taking normalization into account in their half of 2018. There should be less impact on short average life mort-
investment decisions. gage pass-throughs.

Previously, based on the Fed’s Reinvestment Policy, the Fed would
reinvest all principal payments from maturing assets in the bond
markets to maintain a constant balance sheet size. With balance sheet
normalization, since the Fed has limited reinvestments to principal
proceeds above the cap, balance sheet runoff increases Treasury and
agency MBS supply in the market. To compensate investors for increased
volatility risk from the Fed’s reduction in holdings, yields will likely
move higher to an extent. However, the rise in yields will likely be
partially offset by increased demands from investors, both foreign
and domestic, taking advantage of higher yields.
Treasuries impact
The Fed owns about $2.5 trillion in Treasuries, which is equivalent to
approximately 18% of the government debt held by the public. Initially,
balance sheet normalization should have limited impact on Treasury
prices as investors absorb the additional $6B in Treasury supply.
However, as the cap moves higher, balance sheet normalization will
likely steepen the yield curve with long-term Treasury yields increasing
by an estimated 10-15 basis points, while short-term Treasuries will
likely experience minimal impact. We expect this to be an issue
starting in 2018 when Treasury runoff reaches $12B/month.
Agency MBS impact
The Fed owns about 27% of the $6.9 trillion agency MBS market.
Like Treasuries, initial tapering will likely have little effect on MBS
yields as investors absorb the additional MBS supply. Pressure will likely
be felt in April 2018 when the cap increases to $12B/month, cutting
Portfolio positioning to manage downside risk and
generate alpha
In 2017, U.S. news headlines across the screen—historically low bond
yields, rising odds of tax reform under President Trump, stretched credit
and equity valuations—set the backdrop for fixed income investments.
We are in unchartered monetary policy waters with the Fed simultane-
ously unwinding the balance sheet while hiking the Federal Funds rate.
Yet investors appear to be calm as U.S. and foreign cash continues to
flow into the bond markets, and yields compress lower.
The reality is no one really knows, not even Fed Chair Yellen herself,
how the markets will react to the Fed’s unconventional monetary
policy. The Fed’s well-telegraphed statements have prepared investors
for a December 2017 rate hike and gradual balance sheet normaliza-
tion, but uncertainty remains because the timing of future rate hikes
and the pace of balance sheet normalization can be changed based
on future economic conditions.
We continue to invest in areas where we find absolute and relative
value based on asset class, sector, and curve positioning. We are aware
of the economic backdrop, and remain modestly short the benchmarks
to prepare for increases in both short-end rates from future rate hikes
and long-end rates from balance sheet normalization. We continuously
monitor the fixed income markets, the Fed’s statements for changes,
and opportunities for portfolio repositioning. This is our time-tested
investment approach for generating alpha while controlling downside
risks in the fixed income markets.

|  3 |
Market insights | November 2017

CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes but is not limited to Analytic Investors, LLC; ECM Asset Management Ltd.;
First International Advisors, LLC; Galliard Capital Management, Inc.; Golden Capital Management, LLC; The Rock Creek Group, LP; Wells Capital Management Inc.; Wells Fargo Asset Management Luxembourg S.A.; Wells
Fargo Funds Distributor, LLC; and Wells Fargo Funds Management, LLC.
Wells Capital Management (WellsCap) is a registered investment advisor and wholly owned subsidiary of Wells Fargo Asset Management Holdings, LLC. WellsCap provides investment management services for a variety
of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered
as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaran-
teed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its
advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000.
Wells Capital Management does not serve as an independent advice fiduciary during the sales process to any investor.
Distribution in EMEA: Certain subsidiaries of Wells Fargo & Company under the trade name of Wells Fargo Asset Management provide investment advisory services to institutional clients. The rules contained under
the U.K. Financial Services and Markets Act 2000 (the ‘Act’) concerning the protection of retail clients do not apply, nor will the Financial Services Compensation Scheme be available.
The investment may be subject to sudden and large falls in value, and, if it is the case, there is the potential to lose the total value of the initial investment. Changes in exchange rates may have an adverse effect on the
value price or income of the product.
For professional clients only and should not be distributed to or relied upon by retail clients, as defined in the Markets in Financial Instruments Directive 2007. The Financial Conduct Authority rules made under the
Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available.
The information in this document has been obtained or derived from sources believed to be reliable, but Wells Fargo Asset Management does not represent that this information is accurate or complete. Any opinions or
estimates contained in this document represent the judgment of Wells Fargo Asset Management, at this time, and are subject to change without notice. Wells Fargo & Company and its affiliates may from time to time
provide advice with respect to, acquire, hold or sell a position in, the securities or instruments named or described in this document.
For the purposes of Section 21 of the Act, the content of this communication has been approved by Wells Fargo Securities International Limited and ECM Asset Management Limited, regulated persons under the Act.
This document has been approved for purposes of Section 21 of the UK Financial Services and Markets Act 2000 by Wells Fargo Securities International Limited for issue in the UK. Wells Fargo Securities International Lim-
ited is authorised and regulated by the UK Financial Conduct Authority. Recipients of this document should note that Wells Fargo Securities International Limited is not acting for or advising them. The Wells Fargo (Lux)
Worldwide Fund is marketed in Europe by Wells Fargo Asset Management Luxembourg S.A., who is authorised and regulated by the Commission de Surveillance du Secteur Financier (CSSF). Wells Fargo (Lux) Worldwide
Fund is a brand name, and both the Wells Fargo (Lux) Worldwide Fund name and logo are trademarks or registered trademarks of the Wells Fargo group of companies. Wells Fargo Asset Management is the trade name of
the investment management services provided by certain subsidiaries of Wells Fargo & Company.
This document and any other materials accompanying this document (collectively, the “Materials”) are provided for general information purposes. By accepting any Materials, the recipient acknowledges and agrees to
the matters set forth below in this notice.
Wells Fargo Bank National Association (“WFBNA”) makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in the Materials. Information in the
Materials is preliminary and is not intended to be complete, and such information is qualified in its entirety. The views expressed in the Materials do not necessarily reflect the views of Wells Fargo & Company, WFBNA or
their affiliates. The information presented is based upon diverse sources that WFBNA believe to be reliable, though accuracy of the information is not guaranteed.
The Materials are distributed by WFBNA DIFC Branch. WFBNA DIFC Branch is regulated by Dubai Financial Services Authority. WFBNA DIFC branch only deals with Professional Clients as defined by the DFSA.
©2017 Wells Fargo Bank NA. All Rights Reserved.
Distribution in Latin America: Mexico, Chile, Brazil, Columbia and Peru: Wells Fargo & Company provides financial services in Asia, Canada, Europe, and Latin America through its duly authorized and regulated
subsidiaries. In Europe, banking services are provided through Wells Fargo Bank International (WFBI), directly regulated by the Central Bank of Ireland, and Wells Fargo Bank, N.A. London Branch, authorized by the Pru-
dential Regulation Authority (PRA) and regulated by the Financial Conduct Authority (FCA) and the PRA. All products and services may not be available in all countries. Each situation needs to be evaluated individually
and is subject to local regulatory requirements.
Distribution in Canada: The foregoing materials (the “Materials”) are not an offer or commitment for any products or transactions. Our willingness to enter into any transaction is subject to final credit approval,
agreement on transaction terms and compliance to our satisfaction with all applicable legal and regulatory requirements, including onboarding and relationship documentation.  Transactions will only be entered into
with qualified parties in permitted jurisdictions.  Terms, rates, prices and structures in the Materials are indicative only, and should not be relied upon as the terms, rates, prices or structures on which we or anyone else
would be willing to enter into, terminate or transfer a transaction with you, or relied upon for any other purpose. Actual rates and prices may be higher or lower depending on market conditions at the time of execution.
Any historical information provided in the Materials is for information only, and past performance may not be relied upon as a guarantee of future results. Examples in the Materials are hypothetical only and are not a
prediction of future results. There are frequently sharp differences between projections or forecasts and the actual results achieved.
Distribution in Australia: Wells Capital Management is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia.
Wells Capital Management is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to Australian recipients by Wells Capital Management in the course of providing the
financial services will be prepared in accordance with the laws of the United States and not Australian laws.
Distribution in Hong Kong: This presentation is distributed in Hong Kong by Wells Fargo Securities Asia Limited (“WFSAL”), a Hong Kong incorporated investment firm licensed and regulated by the Securities and Futures
Commission to carry on types 1, 4, 6 and 9 regulated activities (as defined in the Securities and Futures Ordinance (Cap. 571 The Laws of Hong Kong), “the SFO”). This report is not intended for, and should not be relied on by,
any person other than professional investors (as defined in the SFO). Any securities and related financial instruments described herein are not intended for sale, nor will be sold, to any person other than professional inves-
tors (as defined in the SFO). The author or authors of this presentation is or are not licensed by the Securities and Futures Commission. Professional investors who receive this presentation should direct any queries regarding
its contents to Ignatius Choong at WFSAL (email: ignatius@wellsfargo.com). Distribution in South Korea: This document is distributed in the Republic of Korea by Wells Capital Management, Incorporated.
Distribution in China: This document does not constitute an offer or solicitation for the provision of investment portfolio management services in the People’s Republic of China (excluding Hong Kong, Macau and
Taiwan, the “PRC”) to any person to whom it is unlawful to make the offer or solicitation in the PRC. Wells Fargo Asset Management does not represent that investment portfolio management services may be lawfully
offered, in compliance with any applicable registration or other requirements in the PRC, or pursuant to an exemption available thereunder, or assume any responsibility for facilitating any such distribution or offering.
Neither this document nor any advertisement or other offering material may be distributed or published in the PRC, except under circumstances that will result in compliance with any applicable laws and regulations.
Distribution in South Korea: This document is distributed in the Republic of Korea by Wells Capital Management, Incorporated.

|  4 |