No 'taper tantrum' as Fed trims balance sheet
Two weeks ago, the US Federal Reserve - already in tightening mode - signaled that it should begin shrinking its US$4.5 trillion balance sheet later this year, yet the markets shrugged off the news.
According to John Normand, JP Morgan’s head of Rates, FX & Commodities Strategy, the markets are rightly unfazed by the minutes from the Fed's March meeting that hinted that moves to trim its giant balance sheet to between US$3.0 trillion and US$3.5 trillion could begin later this year.
“This message has been lost or ignored amongst many other macro themes in play currently including rising geopolitical tensions and the French and UK elections,” the strategist said.
“Fed balance sheet normalisation may also prove a non-event because the strategy was first mooted in 2011 and revised in late 2015.”
Material regime shifts, he continued, like the ones that trigger multi-sigma moves in asset prices come when a policy announcement surprises in its timing and/or its scope, and when markets are characterised by extreme valuations and positioning.
All of which suggests the likely policy shift will go smoothly unlike the “taper tantrum” of 2013 when talk of the Fed reversing its course prompted a sharp bond market sell-off and a dramatic jump in yields.
This time around, hints that the US central bank might begin reducing its balance sheet later this year barely affected yields at all.
“Such is the nature of modest, anticipated policy," Normand argued.
However, the strategist warned that the market is only right to be unfazed if it is making the right assumptions about the pace of shrinkage, the US Treasury's issuance strategy and the composition of the 2018 Federal Open Market Committee (FOMC).
Normand also warned that the Fed’s timetable is slightly more aggressive than the consensus which had expected the roll-off to begin in mid-2018.
“This view is based on FOMC's earlier guidance that it would begin this process once rate hikes were 'well underway', suggesting to many that the official rate would need to be 1-2 per cent before the Fed would tighten financial conditions through the balance sheet as well.”
Further, he added, despite about 18 months of Fed messaging around its likely strategy, there remain many unknowns.
Execute the plan
Normand listed these as whether the run-off will be immediate or phased; how much cumulative run-off the Fed will permit - depending on its optimal balance sheet target - how faithfully the Fed leadership or the broader FOMC will execute the initial plan; and where along the curve the US Treasury will issue to cover its additional funding requirement.
Moreover, Fed Chair Janet Yellen’s term ends in February 2018 and there could be four other new Committee members in 2018.
The JP Morgan strategist is anticipating two rate hikes this year, a December launch of phased run-off of Treasury and mortgage-backed securities reinvestments and three rate hikes in 2018.
Normand calculated that by the end of 2018, the Fed should no longer be rolling over maturing Treasuries and mortgage-backed securities and the official rate should be 2.25 per cent.
By Normand’s reckoning, reinvestment will be phased out over a year; this process will continue until late 2022; reinvestments will resume in 2023 to keep the Fed's balance sheet at between US$3.0 trillion to US$3.5 trillion (compared to US$4.4 trillion currently and US$900 billion pre-crisis); the program will remain on autopilot barring a significant economic shock; and that funding will be at the short end.
“Should the new FOMC prove more aggressive with the run-off for either philosophical reasons or more traditional reasons like quicker inflation, the rise in rates could be quite impactful given the consistency with which some markets react to US rate moves, particularly those at the short end," he said.
In his view, the Fed balance sheet story might become more interesting next year as the European Central Bank also starts tapering in 2017 to end asset purchases by mid-2018. Plus, Normand expects the Bank of Japan to raise its yield target for the ten-year bonds in mid-2018, which would signal tapering less explicitly.
“The ECB and BoJ should each hike once in late 2018, moves that are not currently discounted in money markets.”