Comment: Fed’s balance sheet shrinkage plans cloud rate outlook
By Ipek Ozkardeskaya
The Federal Reserve’s March meeting minutes, released overnight, revealed that the majority of the Federal Open Markets Committee members are willing to start reducing the size of the Fed’s balance sheet in 2017.
Since 2008 subprime crisis, the FOMC tremendously expanded its balance sheet to inject liquidity in the financial system and to bolster the economic growth.
In this context, the Fed’s balance sheet has been multiplied by five in seven years, from $900bn in 2008 to $4.5trn in 2015. To be exact, the Fed currently holds $4,469,618m worth of assets on its immense balance sheet.
Treasury holdings constitute a little less than the half of the total holdings; circa 40% of the Fed’s assets consists of mortgage-backed securities and the rest is made of Federal agency debt, currency swaps and Maiden Lane Net Portfolio.
Timing and size of balance sheet shrinkage are unknown
The March meeting minutes on Wednesday night signaled the Fed is willing to reduce the size of the balance sheet in a "gradual and predictive" fashion, meaning that the bank will not abruptly stop purchasing assets as they mature, yet will likely follow a smoother shrinkage path starting "later this year".
Digging in the dirt of further details, the timing and the amount of the balance sheet reduction seem open to speculation.
To us, the Fed will likely avoid a significant tightening in the US monetary conditions and may not start the balance sheet tightening any time before December.
The tighter balance sheet regime also needs to be conducted with a great care, especially given that the Fed is also committed to raise the interest rates in parallel. Therefore, the amount of the reduction is not expected to be significant, yet remains hard to determine at this stage.
Fed’s Dudley described the balance sheet shrinkage as a ‘substitute for short-term rate hikes’, warning that the balance sheet strategy could bring the Fed to decide whether ‘to take a little pause in terms of raising short-term rates’.
The new piece of information on the balance sheet capped gains in the US dollar, as the Fed rate hike expectations were shortly given back to the doves. The US 2-year yields softened as a result of the minutes, while the 10-year yields held the ground above 2.30%.
June probability rise despite Dudley’s comments
Interestingly, the probability of a June rate hike rose to 63.2% in the dirt of policy details regarding the time and the size of the action on the balance sheet.
In this context, the Fed is still set for two additional interest rate hikes in 2017. Three rate hikes is a possibility and should be factored in the market prices in line with the economic data, and eventually with Donald Trump’s new fiscal policy.
In our view, the downside risks to the June rate hike may have increased. The FOMC’s May meeting could give more clarity to the markets. For now, it appears that the members prioritize the interest rate normalization rather than balance sheet reduction.
US policy remains contingent on economic data
In summary, the Fed minutes gave analysts a new factor to deal with, the balance sheet reduction, adding an additional level of complexity in the Fed’s monetary tightening equation.
As a result, the economic data regains the front stage.
According to the latest ADP report, the US economy added 263,000 new private sector jobs in March, versus 185,000 anticipated by analysts.
The consensus for the non-farm payrolls, due on Friday, is 180’000 versus 235’000 released a month earlier. The 12-month moving average stands at 185’000.
Given the weak expectations, there is room for a positive surprise in March payrolls data.
Ipek Ozkardeskaya is a senior market analyst at London Capital Group