Predictably, the Fed’s “special statement” on the balance sheet normalization plan that accompanied last week’s regular policy statement has precipitated a veritable deluge of analyst commentary which is itself a response to a flood of client questions.
This is ironic, given that the Fed was almost surely displeased with the amount of attention and coverage runoff received during Q4.
Initially, Powell attempted to dismiss the publicity around the balance sheet discussion in the interest of making sure the issue remained as exciting as “watching paint dry”. But thanks in no small part to Donald Trump’s “50 Bs” tweet (which was effectively an advertisement for an already high-profile WSJ Op-Ed), the investing public’s interest was piqued.
By January, it was clear that the Fed would need to address runoff explicitly even if that risked drawing even more attention to a debate they’d rather not be having publicly.
And so, here we are. Runoff is the only thing that matters in the minds of market participants and analysts are scrambling to quantify the mechanical effect of QT on risk assets, even though we still don’t know, with any degree of certainty, what the precise impact of QE was.
We’ve spent so much time on this over the past two months that I honestly don’t think I could catalogue all of the posts off the top of my head if I tried.
Read our most recent QT coverage
Invariably, we’ll end up penning numerous additional missives on this in the week ahead, and to kick things off, it’s worth highlighting a couple of passages and visuals from a Goldman “Q&A on QT” out Sunday afternoon.
We’re just going to skip the bank’s review of the basics given that the vast majority of readers are (hopefully) well-versed.
Diving straight into the bank’s forecasts, Goldman continues to think that the end of runoff will come when reserve balances fall to ~$1 trillion, from ~$1.6 trillion currently (more on that here). To wit:
Reserves currently stand at $1.6tn but are being squeezed in two directions, first by the reduction in the total size of the balance sheet through runoff and second by the growth of nonreserve liabilities such as currency, as shown in Exhibit 3. Our projections imply that reserves will fall to roughly $1tn by early 2020, when the total size of the Fed’s balance sheet stands at about $3.6tn.
In the meantime, Goldman expects more IOER tweaks.
Thereafter (i.e., after the balance sheet reaches its terminal size), it will start growing again “in line with demand for the Fed’s liabilities at roughly the pace of nominal GDP growth”, Goldman writes, adding that maturing MBS will be reinvested in Treasurys in the interest of getting back to a state of affairs where the portfolio is primarily comprised of USTs. You can probably expected active selling of MBS at some point as well, given that simply letting them passively rolloff will take forever.
As far as how runoff is affecting risk assets (and the economy), Goldman reiterates something Deutsche Bank noted on Friday – namely that while the return of duration to the market should in theory push up the term premium, it’s actually fallen, hitting near record lows in Q4.
Goldman goes on to write that this isn’t as simple as “QE in reverse”. For one thing, the bank suggests that the signaling effect of QE (whereby ongoing asset purchases effectively enhanced forward guidance by reassuring everyone that the Fed wouldn’t hike), “is at best inoperative during QT.”
They go to remind you that portfolio effects “are likely to be much smaller now because the balance sheet is likely to shrink as a share of GDP during QT by less than half as much as it grew during QE”. Finally, Goldman clings to the (possibly spurious) notion that the “stock” effect (i.e., the sequestration of assets on the balance sheet) matters more than the “flow” effect (incremental net purchases representing a marginal bid). The upshot is this (from the note):
Accounting for these considerations suggests that the runoff flows that we expect as part of QT are only worth about 50% * 50% * 20% = 5% of the original 75bp impact of QE on 10yr rates, or about 4bp. About half of runoff and therefore half of this flow effect should come in 2019. While there is clearly a fair bit of uncertainty around this estimate, there is strong evidence for the basic point that the share of QE’s peak impact that is being reversed by current runoff flows is very small.
As ever, the mechanical effect isn’t really the issue. Rather, it’s the psychological effect that counts. The market thinks this matters and that can become self-fulfilling.
Indeed, JPMorgan’s Marko Kolanovic last month explicitly said that the sentiment factor is far more important than whatever the mechanical impact is. We variously attempted to warn everyone about that when Trump was busy lambasting the Fed ahead of the December meeting. Here are a couple of quick excerpts from a previous post (and we’ve reprinted these on several occasions to make the same point):
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 [in December].
Goldman drives home the idea that what matters is fragile sentiment and, in the context of diminished liquidity, fragile markets (i.e., both market sentiment and markets themselves are fragile). Here’s Goldman one more time:
With that said, it is clear that amidst the heightened market anxiety that followed the Q4 equity market selloff, a narrative took hold that balance sheet policy was to blame. A self-fulfilling prophecy effect was visible in the adverse reaction to Chairman Powell’s comment at his December press conference that runoff was on “automatic pilot.” The market reaction was a sharp contrast with the muted responses shown in Exhibit 8 to announcements in 2017 in which Fed officials indicated that runoff would begin earlier than expected, an actual policy change. The reaction appeared to unnerve Fed officials enough for them to offer a soothing change of tone and consider changes to the current plan for runoff.
Given that, what comes next in terms of communications and/or actual tweaks to the runoff plan will likely be critical in determining whether the YTD rally in risk assets is sustainable. Over the longer-term, effective communication around the balance sheet will probably be key in keeping volatility suppressed.
Goldman sees three possible options for how things will evolve, the first of which simply sees the Fed sticking to the current plan while simultaneously telegraphing the “likely end-date” for runoff. Of course that risks constraining policy (i.e., reducing flexibility).
A second option could see the FOMC taper runoff by, for instance, reducing the caps (i.e., reversing the dynamic that saw the caps gradually rise). That would naturally push out the end of runoff, but it could allay fears of overtightening. Third, Goldman suggests the Fed could “end runoff early but continue to shrink reserves more gradually through growth of nonreserve liabilities”.
Finally – and this is obviously the “hot topic” among analysts debating how the balance sheet will evolve – Goldman quickly summarizes the case for shifting the maturity profile of the balance sheet (i.e., shortening the average duration). There are a number of reasons why this might be a good idea right now, but for our purposes here, just note that, as Goldman writes, “the motivation would be to provide greater flexibility to lengthen maturity if warranted by an economic downturn.”
In other words, do a reverse Operation Twist now, so that you can roll out Operation Twist Part Deux later. On the left below is the average duration of the Fed’s holdings. On the right, Goldman attempts to show you the asset-purchase equivalent of a new twist based on an initial $3.5 trillion portfolio (the two bars on the left) and also the duration impact of a couple of different combinations of twisting and buying (the two bars on the right). “As a result, we see an eventual deliberate shift toward shorter Treasury maturities– including bills–as likely”, the bank concludes.
You can take all of this for what it’s worth, but the overarching point is that when it comes to whether the Fed is going to be able to go silent on the balance sheet plan after last week’s “special statement”, the answer is “definitely not”. The horse has left the barn. The cat is out of the bag. The genie has escaped from the bottle. Elvis has left the building (I’m not sure that one works).
They (the Fed) are going to have to keep talking about this at fairly regular intervals in order to make sure the market doesn’t get the idea they’ve secretly reverted to the assumption that they can sweep the debate back under the rug after placating everyone following the January meeting.