Shrinkage and Beyond

After much anticipation, the FOMC decision day is here. Much of the focus is on the likely
decision that the Fed will allow its balance sheet to shrink gradually.
 No other country who employed quantitative easing has is in a position to
begin unwinding the emergency expansion of its balance sheet.  The Fed’s
experience in QE, communication, and now unwinding, will be part of the
information set other central banks can draw upon. 

Initially, the idea of unwinding
the central bank’s balance sheet seemed to entail the sales of
securities.  However,
the FOMC’s strategy is not to sell a single security, but simply slow the
reinvesting of the maturing issues.   We suspect this is likely to be the
main path for other central banks, eventually, as well.  The reinvestment
of maturing securities was roughly equivalent to 40% of the deficit last year.
 

Many worry that if the Fed
is absorbing the supply, the market will, and the key is the price that is does
this.  However,
much of the thinking seems confused because many insist that interest rates are
low because the central banks have been buying bonds.   The story is more
complicated.  Remember, US yields typically rose while QE was active and
fell when the buying ceased.   We argue that the real reason
rates are low is that growth and inflation are low, and that the supply of
capital exceeds its effective demand.

The impact of the gradual
unwinding of the Fed’s balance sheet is not known. Many, like us, expect the very low
starting point ($10 bln a month for the first three months), is unlikely to be
disruptive.  The signaling impact has also been modest. Surveys have shown
that majority have expected that today’s meeting would be the forum for the
policy announcement.  It did not prevent the 10-year yield from falling to
new lows of the year a couple weeks ago.  

Another way to say this is
that there is a myriad for factors that drive US interest rates.  Fed actions are important but there are
other factors that could overwhelm.  For example, this year, as China’s
reserves have begun growing this year after falling.  As China’s reserves
grow, its demand for Treasuries has grown.  According to US data, and not
doing what seems to be the popular thing, attributing other financial center’s
holdings of Treasuries to China, China’s holdings of Treasuries have risen by
$108 bln through the first seven months of the year.  

While the focus is on the
Fed’s balance sheet and its unprecedented initiative, we suspect the market’s
reaction to today’s meeting will not come so much from that–which has been so
highly anticipated.
 Rather we suspect that the new economic projections will be more
important.  It will be the first time that it extends the forecasts
through 2020.  This is important because it will give investors a better
sense of where the Fed may see the terminal rate for Fed funds.  The
question is will the dot plots point to Fed funds peaking in 2019 and flat in
2020?  The Fed could slow its projected trajectory so that it shows rates
still peaking at the same level but taking longer to reach it.
 Alternatively, it could show rates continuing to rise in 2020 so the peak
or equilibrium level is higher.  

Another underlying issue is
the significance of the projects when the composition of the Fed’s Board of
Governors is going to change so profoundly in the coming quarters. We think that continuity at the Fed will
be greater than the partisanship suggests.  Moreover, we suspect the
market continues to under-estimate the likelihood that Yellen is reappointed.
 We are sensitive to the precedent of two terms and appointment by
presidents of both parties (Volcker, Greenspan, Bernanke).  

Yet, we are also well aware
that President Trump shows no particular fondness for tradition or precedent.  Nevertheless, the
re-appointment of Yellen may serve the President’s interest.  It is an
easy appointment.  It will not antagonize his base which appears focused
on other things.  Although Yellen has endorsed a strong regulatory
environment, would any other person with the requisite experience to get the
job, do otherwise.  Even Greenspan has delivered a mea culpa over the
belief that financial institutions would regulate themselves.  Cohn’s
chances to replace Yellen have seemingly been downgraded, and former Governor
Warsh’s candidacy may look more promising, but in PredictIt, Yellen is seen by
the gamblers, as the more likely, but odds are still seen only slightly better
than 1 in 4.  

The US dollar is going into
the FOMC meeting offered.  The
euro is at the upper end of this year’s range, straddling the $1.20 area.
 There is a 500 bln euro option struck at $1.1950 and 1 bln euros struck
at $1.20 that are cut in NY today.  

Strong UK retail sales
report and anticipation of May’s speech at the end of the week has lifted
sterling back toward $1.36.  The recent peak was near $1.3620.  It had found a bid a
little below $1.35.  The Financial Times reports that May will offer to
pay into the EU budget through 2020, at a cost of about GBP20 bln.  This
reportedly will be discussed in a cabinet meeting ahead of May’s speech in
Florence on Friday.  Retail sales jumped 1% in August, with and without
petrol, and the July figures were revised higher.   

There is some suggestion
that foreign consumers may have flattered the sales by taking advantage of the
weak sterling to buy jewelry and watches, while sales of clothing, footwear,
and household goods were softer.  Regardless of the details, the optics have fanned rate hike
expectations and the implied yield of the Dec short-sterling futures contract
has edged higher to its best level since February.  

The dollar peaked shy of
JPY112 yesterday, briefly surpassing the 61.8% retracement of the drop from the
July high near JPY114.50.    The dollar is trading slightly heavier today.
 The last session that the dollar fell against the yen was last Thursday,
and it also corresponded with a decline in US 10-year yields. US 10-year yields
have risen seven of the last eight sessions coming into today, and yields are a
little softer after reaching almost 2.25% yesterday.  

The dollar-bloc currencies
are bid.  Comments
by the Deputy Governor of the Bank of Canada had seemed to signal that a follow
up rate hike at next month’s meeting is unlikely.  We did not attribute a
strong chance that the Bank of Canada would have hiked rates at three
consecutive meetings, and with the help of the guidance, the market has reduced
the odds.  However, another hike before the end of the year is nearly
fully discounted (OIS) which means the December meeting.  The US dollar
traded higher against the Canadian dollar when the comments were made on Monday
and has since been trading in narrow ranges with a softer bias.