About three weeks ago, we talked a bit about the Fed’s options in terms of how to go about pairing FF hikes with SOMA rolloff and/or asset sales.
There’s an argument to be made for using the balance sheet to tighten rather than outright hikes as the assumption is that stopping reinvestments or outright selling assets would affect the long-end more than the short-end and thus would be more dollar neutral.
Why is that important? Well, because the Fed needs to be cautious about creating a situation where the argument for a structurally stronger greenback is so strong that it ends up triggering EM chaos and/or irritating a White House that’s hell-bent on keeping a lid on USD strength. As a reminder, here are the Fed’s options:
All of this is made even more interesting by recent curve flattening, the rapid unwind of the 10Y short, and the still record eurodollar short.
Here with more on all this and why the Fed needs to be really – really – careful when it comes to “embarking on projects” just for the sake of embarking on projects is former FX trader Richard Breslow.
Somebody had better give this all a lot more thought before starting to put potential time parameters on when we might be setting off on this treacherous trek. The journey I’m referring to is ending the reinvestment of maturing securities held on the Federal Reserve’s bloated balance sheet.
- All of a sudden, we’re not hearing its a noble goal, deserves study and should start after considerable progress has been made in raising the Fed Funds level toward the neutral rate — the argument upon which the Fed’s dot plots are supposedly based. We’ve just had three Fed speakers, including NY President Bill Dudley, mention the latter part of this year as potentially appropriate. This is a big change and a very big deal
- With all due respect to everyone with an opinion on this subject, no one knows how this is going to work in practice, let alone what it will do to markets
- If stability of financial conditions is the unofficial third mandate then buckle up. It could be like being the passenger in a car driven by someone struggling to work out getting from neutral into first gear on a steep hill
- Remember when we were assured that dealing with disinflation was the hard part, and there was a plan for how it would all get unwound? It sounded good at the time. Buying securities on a well advertised schedule was not the tour-de-force. Reducing holdings on a potentially start stop basis will take the real moxie
- In the last two weeks we’ve gone from risk-off to risk-on to, this morning, when the jury is out. Will the Fed be able to ignore these bouts of severe mood swings, especially if they’re longer lasting? They’d better. But as Dudley said, projections are forecasts, not commitments. Now multiply the complexity if we’re talking asset dispositions instead of 25 basis point hikes
- Just for a little context, Bloomberg’s Stephen Spratt calculates that the balance sheet’s Treasury holdings longer than 20-years maturity represents a full three years worth of long-bond supply. Not even mentioning all the MBS. How’s that for crowding out? And how many years is this going to take? Ever wonder why corporate America is stockpiling cash?
- Getting the balance sheet down is an important long-term objective. Long-term thinking is not something we’re good at. But doing it without a lot of Fed Funds firepower to facilitate it is not going to be smooth. Embarking on this project merely to claim it as a milestone would be a policy mistake