Earlier today, we brought you the latest from Bloomberg’s Richard Breslow, who warned that the Fed might want to think long and hard before they start letting their portfolio roll off or start selling assets outright.
As a reminder, here are the relative “benefits” of FF hikes versus using the balance sheet to tighten:
(Goldman)
As we also noted, there’s considerable debate about the FX impact of one approach versus the other. More specifically, one argument for using the balance sheet is that it would have less of an effect on the dollar which, Q1 weakness notwithstanding, is probably just one solid argument for structural strength away from getting back on the horse (we saw that last week with the engineered return to policy divergence).
There’s also some “tantrum” risk involved here. As Breslow noted, no one knows how this is going to affect markets and although the idea of a tantrum might seem out of synch with reality given what we’ve seen in yields since the dovish hike and especially what we’ve seen so far this week, it’s nevertheless worth noting that during the taper tantrum, the 10-year Treasury yield increased from an intra-year low of about 1.6% on May 2, 2013, to more than 3% by year end.
Well, as you ponder this, consider the following from everyone’s favorite Street economist, Deutsche Bank’s Joseph LaVorgna and please, try to restrain yourself with the “forehead” and “weather” jokes…
Via Deutsche Bank
Monetary policymakers have recently upped the ante on forward guidance regarding the Fed’s balance sheet strategy. Recall that the size of the Fed’s balance sheet is currently about $4.5 trillion, compared to less than $1 trillion before the financial crisis. Although the Fed has kept the size of its balance sheet steady since December 2014, its longer-term goal is to cut the balance sheet down to roughly the minimal size necessary to conduct its open market operations, by allowing maturing Treasuries and MBS to roll off.
The challenge for the Fed is that the tapering of its balance sheet is likely to induce financial tightening, essentially reversing some of the allegedly positive effects of quantitative easing (QE). However, the extent of this tightening is highly uncertain because QE was an unprecedented policy experiment. For this reason, policymakers have stated that they will address the balance sheet after policy rates are lifted well above zero. Now that the Fed has raised rates by 75 basis points in aggregate from the “zero lower bound”, the Fed’s balance sheet strategy is coming into focus. Last week, New York Fed President Dudley suggested that he expects balance sheet normalization to start in late 2017 or early 2018. This would be after about two additional rate hikes, likely in June and September, in our view. Also last week, San Francisco’s Williams stated that he favors two to three rate increases this year, after which he would start to become comfortable with tapering the balance sheet.
Even some relatively dovish FOMC participants have argued in favor of addressing the balance sheet sooner rather than later. St. Louis Fed President Bullard, who is not forecasting any additional rate hikes through the end of 2019, has recently argued that balance sheet cuts could begin in the second half of this year. Minneapolis’ Kashkari, who dissented against the March rate hike, said that his dissent was in part due to his view that the Fed should announce its balance sheet strategy, and assess the reaction of financial conditions, before embarking on further rate increases.
This recent Fedspeak is consistent with our forecast that the Fed will raise rates two more times this year, in June and September, before taking a pause in December to announce the run down of its balance sheet. The taper is expected to begin in next year. Barring an economic downturn, we expect the Fed to adhere to its objective of running the balance sheet down in a highly predictable manner, using the fed funds rate as its primary policy tool. Nonetheless, the pace of adjustment of the fed funds rate will likely be affected by the tightening effects of balance sheet normalization, a factor that both Dudley and Williams acknowledged in their recent comments. For example, during the taper tantrum, the 10-year Treasury yield increased from an intra-year low of about 1.6% on May 2, 2013, to more than 3% by year end. This turned out to be an overshoot, however, because over the course of 2014 the 10-year note retraced much of its sell-off, ending the year below 2.2%.
The Fed will attempt to avoid a repeat of the taper tantrum by thoroughly preparing the markets before starting to cut its balance sheet: Recent commentary by policymakers was likely just the start of the Fed’s forward guidance efforts. Investors will be looking for additional clues on the balance sheet in [tomorrow] afternoon’s release of the March FOMC minutes.
