Everything was going along fine until someone mentioned the balance sheet.
Jerome Powell of course spoke on Thursday at The Economic Club of Washington and let us start by saying that he was visibly relaxed, cracking jokes from the outset and deftly navigating questions about the December meeting minutes and the rate path.
It’s clear that his learning-by-doing approach is paying dividends and he now seems to have figured out how to blend “plain English” with enough obfuscation to placate markets. It probably helps that stocks have staged an absurd rally off the December 26 overnight lows and you can be absolutely sure that ol’ Jay has noticed the “rave” reviews the market gave him for comments delivered last Friday in Atlanta (under the watchful eyes of Yellen and Bernanke, who presumably would have just cut him off had their spidey senses started telling them stocks were falling).
Powell had an easy setup for Thursday’s remarks in Washington. Wednesday brought a veritable procession of dovish Fed speakers who together tanked the dollar and bolstered stocks in the hours before the December minutes hit. The account of the December meeting clearly suggested that it was the Powell presser that was the “problem” not the meeting itself. That is, it was another communications misstep from a rookie.
Well, suffice to say Powell has served notice that he isn’t a “rookie” anymore as he starts his second year at the helm. Generally speaking, his remarks in Washington were well received, on message and sprinkled with (more than) enough ambiguity to satisfy markets that he “gets it” when it comes to the extent to which “transparency” paradoxically demands more obfuscation, not less. He even got in a joke about his non-credentials as an economist, noting that he knows a “guy” who started a successful PE firm without a business degree (the implication being that there’s hope for his chairmanship yet).
But then, he was asked about the balance sheet. Here’s what he came up with, in bullet point format:
That bit about wanting to return the balance sheet “to [a] more normal level” might sound like a man just stating the obvious, but it’s not 100% clear that “normal” is the best descriptor there given that if you go by historical precedent, we’re “a long way from normal” (to paraphrase the worst communications fumble of Powell’s short tenure).
But (far) worse than that was his ill-advised decision to describe the eventual size of the balance sheet as “substantially” smaller. That was an unforced error. There was no reason to use “substantially” and the market immediately seized on it.
For fun, here’s an updated version of the annotated futures chart.
As we (and plenty of others) have variously suggested, the balance sheet discussion is now perhaps more important than the rate path discussion. The market has already priced out rate hikes (for the most part) and the Fed’s dovish relent on that front has been unequivocal over the past couple of weeks. That, it would appear, is already in the price – figuratively and literally.
As Powell well knows – just ask the transcript of the October 23-24, 2012 FOMC meeting – “it will never be enough for the market”, and right now, the market wants a clear sign that balance sheet runoff will be reconsidered.
Powell gave the market an inch, and now it wants a mile.
This may all sound highly absurd (and extremely unhealthy) to you and to be clear, it is. That said, we are where we are. DM central banks embarked on a historic experiment and unwinding that experiment is going to be a delicate task.
But beyond that, one of the main issues with Fed balance sheet rundown is that it’s colliding with increased Treasury supply to sap liquidity from other assets. You’ve got a price insensitive bid from the folks with the printing press being pulled away just as Treasury is issuing a deluge of debt. Well, someone has to absorb all of that net supply and because the market for USTs will always clear (although “at what price?” is becoming an increasingly important question amid signs of waning demand), liquidity is sapped from riskier assets. Former RBI governor Urjit Patel tried desperately to warn the Fed about this last summer.
On the bright side, that was Powell’s only misstep on Thursday. And it didn’t cost much in the way of S&P points. Or at least not as of 2:00 PM in New York.