Tags: Fed | Shrinking | Balance | Sheet | Bond | Yields

Fed's Shrinking Balance Sheet May Pressure US Bond Yields

Fed's Shrinking Balance Sheet May Pressure US Bond Yields
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Thursday, 15 June 2017 02:11 PM Current | Bio | Archive

Federal Reserve Chair Janet Yellen’s press conference after the Federal Open Market Committee had decided to raise interest rates by a quarter of a point was really an interesting one.

It’s a fact that at present the U.S. economy is apparently facing a soft path, which was confirmed by the Fed's monthly index of industrial production and capacity utilization rates that shows industrial production was unchanged in May following a large increase in April and smaller increases in February and March.

Manufacturing output declined 0.4 percent in May while the index is little changed, on net, since February. Capacity utilization for the industrial sector edged down 0.1 percentage point in May to 76.6 percent, a rate that is 3.3 percentage points below its long-run (1972–2016) average.

Notwithstanding that, Yellen used yesterday’s opportunity to announce, as one could say, a cunning plan, and wherein was clearly outlined how the $4.47 trillion balance sheet of the Fed will be reduced.

Treasury bonds and mortgage-backed securities represent about $4.23 trillion, of which most were purchased in the wake of the 2007-2009 financial crisis and recession.

The announced phased reduction of the Fed’s bond purchases would start with $6 billion a month from Treasuries and $4 billion a month from mortgage bonds, increasing each quarter until the Fed’s balance sheet is being reduced by a total of $50 billion a month or $600 billion per year.

Yellen said: “What I can tell you is that we anticipate reducing reserve balances and our overall balance sheet to levels appreciably below those seen in recent years but larger than before the financial crisis” and added that the balance sheet normalization could be put into effect "relatively soon."

By the way, the Fed’s balance sheet stood at $869 billion on August 8, 2007.

The interesting point of announcing this carefully constructed plan now is that, should Yellen’s four-year term that ends on February 3, 2018 not be renewed, then the next Fed Chair will struggle against the constrains of the program and find it difficult to change the plan.

Yes, it looks like Yellen has set in place a tightening strategy for quantitative policy that will likely endure.

What could this mean for markets and thus investors?

Investors should better not overlook the fact that shrinking the Fed’s balance sheet via Quantitative Tightening has never happened before, and therefore it might be hard to discount it…

The consensus belief is that a shrinking balance sheet will add upside pressure on U.S. yields via bond supply/demand effects. This is thought to tighten financial conditions, providing the Fed with less scope for rate hikes in 2018.

However, it could be that it will provide easier financial conditions and thus more scope for hikes.

Or, as, the post-crisis empirics of the Fed’s QE programs, or rather the lack thereof, suggests both of these views could be wrong.

Yes, a complex situation is coming our way.

Quantitative Tightening implies “un-printing” of money for an amount of around $600 billion per year, which is huge, and that could in my opinion, probably result in a higher dollar as well as higher “real” rates - despite lower nominal yields.

Now, that “un-printing” momentum caused by Quantitative tightening suggests that the euro could come under new pressure against the dollar, which is completely the opposite of what markets have priced in at the moment.

Under this scenario, also high-yielding currencies (Emerging Markets or EM currencies) are also prone for depreciating against the dollar (G-10 FX carry index).

Finally, on inflation, Yellen said:

“With employment near its maximum sustainable level and the labor market continuing to strengthen, the Committee still expects inflation to move up and stabilize around 2 percent over the next couple of years, in line with our longer-run objective.

“The median projection for growth of inflation-adjusted gross domestic product (or real GDP) is 2.2 percent this year and edges down to 1.9 percent by 2019, slightly above its estimated longer-run rate. The median projection for the unemployment rate stands at 4.3 percent in the fourth quarter of this year and ticks down to 4.2 percent in 2018 and 2019, modestly below the median estimate of its longer-run normal rate. Finally, the median inflation projection is 1.6 percent this year and rises to 2 percent in 2018 and 2019.”

Etienne "Hans" Parisis is a bank economist who has advised global billionaires and governments on the financial markets and international investments.

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The consensus belief is that a shrinking balance sheet will add upside pressure on U.S. yields via bond supply/demand effects. This is thought to tighten financial conditions, providing the Fed with less scope for rate hikes in 2018.
Fed, Shrinking, Balance, Sheet, Bond, Yields
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2017-11-15
Thursday, 15 June 2017 02:11 PM
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