The second problem is how the Federal Reserve will finesse shrinking its balance sheet. Once the Fed stops buying Treasury bonds and MBS, the Fed’s balance sheet will become smaller over time, as some of the Treasury bonds and MBS it has purchased mature. We do not know if the Federal Reserve has the option of just holding the balance of its Treasury bonds and MBS to maturity. If they don’t have that option, managing their balance sheet could become a significant challenge. If and when the GDP growth is maintained above 3%, and the unemployment rate approaches 6.5%, the bond market will anticipate the time when the Federal Reserve will begin to contemplate raising short-term rates. Although this may not happen until 2015, the hawks on the FOMC are likely worried about the Fed becoming the proverbial elephant in a china shop. Imagine where yields might climb to if the Fed begins to sell off its Treasury and MBS holdings into what could be a weak bond market. Speaking at the Rocky Mountain Economic Summit on July 12, the President of the Federal Reserve of Philadelphia – Charles Plosser – addressed the potential for volatility in the bond market.
“Financial markets are unlikely to be patient as we unwind from this extraordinary accommodation. The recent volatility in interest rates may be a taste of things to come.“
The Federal Reserve has set the markets up for a true communication breakdown, since it has repeatedly said scaling down its QE3 purchases is data dependent. However, it cannot allow the size of its balance sheet to grow indefinitely. The Fed has endeavored to keep mortgage rates down to spur a recovery in housing and they do not want to see five years of monetary policy accommodation unwound by the bond market in a matter of months. So far financial markets have responded much like a teenager who has just been told they can’t go to the party, after they were told they could. In order to close the communication gap between data dependent tapering and tapering irrespective of the data, the FOMC will choose an approach that minimizes the negative impact in the financial markets. Let’s hope the financial markets do not throw a miscommunication tantrum.
The Bureau of Labor Statistics’s August employment report released on September 6 is likely to be influential, since it will provide the last reading on the health of the labor market before the September 17-18 FOMC meeting. A recent poll by Bloomberg found that 65% of economists expect the Federal Reserve to start tapering in September. Perversely, a weaker than expected employment report could help stocks and bonds rally, since it might give markets hope that the amount of tapering will be small or the onset delayed.
We expect more ‘moping along in the middle’ to quote president of the Federal Reserve of Atlanta Dennis Lockhart. We think the FOMC will address the size of the Fed’s balance sheet by announcing the details of its QE3 tapering program after the September 17-18 meeting. Markets do not like uncertainty, and providing the details of its plan for tapering will help the financial markets. If the Fed does what we think is likely, the financial markets might conclude the world is not about to end, which could help Treasury bond yields fall. The stock market is likely to benefit even more than the bond market from clarity, especially if Treasury yields drop.
As noted in our July commentary, we expect a compromise to develop that addresses the concerns of the doves and hawks within the FOMC. Recent data has not clearly supported lowering the amount of QE3 purchases, and the increase in mortgage rates has to be a concern for doves and hawks alike. Given the recent spike in interest rates, moderates should have more leverage to push for an extremely gradual approach as a compromise for addressing the Fed’s balance sheet. One approach would be to reduce its purchases each month by $10 billion, which is less than the $20 billion bandied about by market commentators. A better alternative would be to use a stair-step approach that would have the Fed reduce its QE purchases by $10 or $15 billion, and then wait until the next meeting before any further action. Because the stair-step approach has pauses already built into the process, it would readily allow the Fed to postpone additional reductions in QE3 if the economy weakened. This would certainly appeal to the moderates and doves on the FOMC, who would prefer more time and more data as QE3 is wound down. And for the hawks, even a small reduction would be a first step in ending QE3.
No matter what approach the Fed chooses, the Federal Reserve will repeatedly remind investors that they plan to keep short-term interest rates near zero, at least through 2014 and possibly longer. Keeping short-term rates low will help keep intermediate-term (5 to 10 years) Treasury rates anchored and benefit mortgage rates. A recent analysis by the San Francisco and New York Federal Reserve districts of the $600 billion in QE2 purchases published on August 12, concluded interest rate forward guidance had a greater economic effect than signals about the amount of assets purchased in QE2. They estimated that QE2 added just 0.13% to real economic growth and 0.03% to inflation. The hawks on the FOMC can point to this report as another reason why the risks from the growing size of the Fed’s balance sheet outweigh the economic benefits of continuing QE3 at its current level.
The Fed is likely to say that reducing their QE3 purchases is independent from any decision to increase rates. The Fed may also suggest that curbing QE3 buying does not represent a tightening of monetary policy. We would disagree with that assessment. With its monthly purchases, the Federal Reserve is providing liquidity to the bond market by reducing the supply of bonds in the market. As the Fed lowers its purchases, the reduction in Fed demand must be replaced by other market participants. With yields spiking higher in recent weeks, market participants have been unwilling to step up their purchases until they know more about the Fed’s plans. Since the Federal Reserve’s purchases of Treasury bonds and MBS has distorted prices in these markets, the markets are seeking and establishing a new equilibrium price level ahead of the onset of Fed tapering. Financial markets often over react, which suggests a good trading opportunity in the bond market is coming. According to Bloomberg, yields on 10 and 30-year Treasury bonds have soared from 1.61% and 2.92% in mid May to 2.86% and 3.93%, as of August 22. Although the Federal Reserve has not tightened policy, the bond market certainly has, so it would be disingenuous for the Federal Reserve to say the tapering of QE3 does not represent a tightening of monetary policy.
The Fed will try to strike the right balance to bring rates down to unwind some of the market’s tightening.
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