I guess the Fed decided it was time call up WSJ’s Nick Timiraos and ask him to float another trial balloon.
Back on December 6, Timiraos penned a fortuitously timed 492-word “article” clearly designed to juice markets by tipping an imminent Fed pause. “[As the Fed] push[es] up their benchmark, they are becoming less sure how fast they will need to act or how far they will need to go and want to assess how the economy is holding up under moves they’ve already made”, Nick wrote, in a piece that hit about a half hour before the close and served to catalyze a quick ramp.
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Thursday’s Big Story Wasn’t WSJ’s Fed ‘Scoop’ — It Was The Short-End Circuit Breaker
Of course Powell ended up fumbling the handoff two weeks later at the December press conference, but that WSJ post served as a kind of Cliffs Notes version of the November Fed minutes and set the stage for what, by mid-January, had morphed into an all-out dovish relent on the rates path.
We’ve variously argued that the Fed has likely squeezed all the juice out of the “pause” story and that, should the outlook darken anew, officials would likely need to tip a rethink of balance sheet runoff if they wanted to engineer another rally.
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Damned If They Do, Damned If They Don’t: Fed May Be Boxed In On Balance Sheet
Implicit in our commentary on this is the idea that Powell and co. would wait until volatility returned, but it’s probably not a stretch to say that they are becoming increasingly wary of the government shutdown and the prospect that the protracted impasse inside the Beltway could end up colliding with a “no deal” moment on trade talks (not to mention debt ceiling jitters) to push markets in the “wrong” direction.
Cue this, from a piece out Friday morning from Timiraos:
Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.
Officials are still resolving details of their strategy and how to communicate it to the public, according to their recent public comments and interviews. With interest rate increases on hold for now, planning for the bond portfolio could take center stage.
That is worded exactly like Nick’s December article and while it’s basically just a preview of the Fed meeting, it suggests that Powell is now actively considering whether to give in and perhaps alter the language around balance sheet runoff to ameliorate concerns that “auto pilot” is wholly inconsistent with the idea that policy isn’t on a “preset” course.
We’ve been over this at least a half-dozen times this month, most recently last Friday, in the course of giving you some excerpts from a recent Marko Kolanovic note in which the most recognizable name on the Street suggested the psychological impact of QT is far more important than whatever the mechanical impact of balance sheet rundown is. Here’s Marko, for those who missed it:
Whatever the real mechanical impact is, likely the impact on market sentiment is much larger (i.e., self-fulfilling impact). In support of that are recent intraday movements on balance sheet mentions, as well as the price action of the S&P 500 during Q4 shown in Figure 8. While there may be little or no mechanical impact on equity prices, most macro traders are not ‘fighting the Fed’ — when liquidity is added they are buying assets, and when liquidity is removed they are selling assets.
This is why it was so dangerous for Donald Trump to take to Twitter to lambast the Fed’s balance sheet rundown. It drew attention to something that most people had no idea even mattered.
That increase in public awareness likely exacerbated the negative market impact from the December Fed meeting and especially from Powell’s presser. Balance sheet runoff was supposed to be “like watching paint dry”, but by tweeting out a reference to a high profile WSJ Op-Ed, Trump effectively turned “watching paint dry” into a national pastime.
Markets were thus more vulnerable to Powell’s “auto pilot” characterization and that vulnerability (read: predisposition to overreact by selling on any discussion of the balance sheet) collided with a dearth of liquidity last month.
Read more on the mechanical impact of QT
Ok, Sure! I’ll Take A Look At That Fed MBS Runoff Vs. S&P Returns Note…
While there is no accepted “standard” for quantifying the mechanical impact, Morgan Stanley took a stab at it earlier this month and we documented that effort in the linked post above. The gist of it is that MBS runoff matters more than Treasury rundown.
With all of the above in mind, this seems like an opportune time to highlight a couple of quick passages from a recent Nomura note on the topic.
“By the start of Q4 the Fed had finished methodically raising the caps on monthly roll-off of its balance sheet to the full $50bn per month ($30bn USTs, $20bn MBS) and by end-Q4 markets also experienced some of the largest volatility and drawdowns in nearly a decade”, the bank’s George Goncalves wrote last Friday, before delivering the following assessment that echoes the points made above:
Coincidence, perhaps or perhaps not, but broader markets have questioned the Fed’s original view that B/S roll-off was going to be like “watching paint dry.” Recent Fedspeak has shifted to being more open-minded, with Fed policy makers suggesting that they are prepared to be “flexible” in implementing their balance sheet policy. In our view B/S normalization is far from done, but is likely to see some tweaks ahead. For example, recent FOMC minutes suggest it is looking at B/S policy ideas to address the inter-play between setting overnight interest rates and excess reserve dynamics.
After diving into the how the evolution of rolloff will change SOMA’s duration profile, Goncalves reminds everyone that he’s been looking at the impact of QT since at least last summer. He notes that Nomura’s analysis generally saw “little correlation of the smaller B/S to the S&P 500, unlike what was seen during the QE days where stocks had an eerie visual relationship to the actual size of the B/S.”
That said, he did observe that weekly changes to the balance sheet might be affecting markets. “For example, the weeks where MBS holdings were paying down and/or weeks around the time the total size of the roll-off for both UST and MBS exceeded $20bn, markets would come under pressure with the most striking of those periods at the time being the February VIX shock”, he writes.
Ultimately, Goncalves’ analysis strikes a kind of middle ground between those who say the mechanical impact is impossible to estimate and thus the psychological effect (in the context of a diminished bottom-up liquidity environment) is what matters and those who think it is indeed possible to pin down the mechanical effect. We’ll leave you with his conclusions presented without further editorializing:
We believe QT is tightening, however it is not straight forward and seems to come in rolling aftershocks of liquidity draining and markets adjusting positions. The MBS QT piece makes sense as those securities are not zero-risk weight (as are USTs) and take up capital and/or need to be a substitutes for other credit products (which impacts FCI). Last, we see that the “B/S dispersion”, a measure of the week on week B/S changes, have a good correlation with market-measures of volatility. Dispersion is calculated as the spread between the maximum and minimum weekly change in a rolling 3 month window. Q1 dispersion is poised to subside before a pickup in potential vol in late Q2.
So my comment is this…….Everyone who did not see this coming please raise their hand ……