Balance Sheet Reduction To Begin In October!
In its latest monetary policy decision, the US Federal Open Market Committee (FOMC) announced that in October, "the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee's Policy Normalization Principles and Plans." This is done via the gradual reduction of its reinvestment of principal payments received from its existing holdings of Treasury securities and agency mortgage-backed securities (MBS). The Fed will trim reinvestments in US Treasuries by USD 6 billion per month and in mortgage-backed securities (MBS) by USD 4 billion per month. These reductions in reinvestments will expand on a quarterly basis until it reaches USD 30 billion per month and USD 20 billion per month in US Treasuries and MBS (estimated by 3Q 18). The Fed did not specify when the normalisation process would end. This latest move (balance sheet reduction) was largely expected by financial market participants due to the thorough communication by Fed members throughout the third quarter.
Contributing to the Fed's decision was its analysis that the "job gains have remained solid in recent months", and that household spending "has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters." With regards to the impact of the recent weather events in the southern regions, the Fed commented that "Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term." The Fed also added that "higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily", indicating that policy-makers are looking through the adverse effects of the recent natural disasters and are confident that growth in the US remains robust.
Rates Left Unchanged, But Guidance Similar
The Fed Funds rate was left unchanged at 1.00% - 1.25%. With regards to its guidance on the Fed Funds rate, the FOMC members have maintained their forecasts, subsequently maintaining the median trajectory as seen in the "Dot Plot" chart in Chart 1 below. This indicates that policy-makers are expected to hike the benchmark rate one more time in December, and another 3 times in 2018. Consequently, markets have also repriced the odds of a rate hike by the year's end (from a 53.2% probability to a 63.8% chance).
Chart 1: Fed's "Dot Plot"
The only change was the decrease in the median 'Dot Plot' projection rate for 2019 (down to 2.70% from a prior 2.90%) and that the terminal rate has also been lowered to 2.80% from a prior 3.00%. GDP growth forecast for 2017 has been upgraded 20 basis points to 2.4%, while GDP forecast for 2018 remains unchanged at 2.1%. Core PCE for 2017 was moved lower to 1.50% (by 20 basis points), while 2018's headline and core PCE inflation forecasts were lowered by 10 basis points each respectively (to 1.9%).
Market participants were caught slightly off-guard and interpreted the latest announcements as slightly 'hawkish', with initial market reactions include a rise in yields across the US Treasury yield curve. The yield on the US 10-year Treasury rose from a prior 2.23% to 2.27%, while the US 5-year Treasury yield ended the trading session with a yield close to 1.88% (from a prior 1.82%). The S&P 500 Index saw an initial minor decline before the Fed's announcement before rebounding and ending the trading session at 2508 (+0.06% from the previous day). In the foreign exchange markets, the USD strengthened across the board against developed and emerging markets currencies, with the US Dollar Index up more than 1.00% (and the JPMorgan Asia Dollar Index declining) from the time of the FOMC meeting into the Asian trading hours at the time of writing.
What Now? Implications & Takeaways
Since the 1980s, each rate hike cycle was different in terms of duration and magnitude (the total amount of percentage points hiked) – they vary in length and extent. This serves as a reminder that every cycles has its own characteristics and needs to be assessed against respective macroeconomic backdrops. This current cycle may thus differ in respect to the current context as well as its historical precedents.
What we’ve learnt thus far in this current business cycle is that US policy-makers at the Fed have tended to ensure that market participants are aware of their intentions: any policy changes have always been preceded by a process of communication, and any action undertaken has always been done in a measured and gradual manner. This has been seen since the days of Operation Twist as well as the unwinding of ‘Quantitative Easing 3’, more commonly known as the tapering.
With this new balance sheet reduction programme ongoing, policy-makers are likely to continue the same measured and prudent approach, communicating to markets their expectations and allowing time for adjustments to take place. The programme will kick off in a small way, and is expected to take a lengthy period of time before the Fed's balance sheet is considered to be at a normalised level. Additionally, we would like to remind investors that it is vital to note that the Fed's guidance is still data-dependent, giving them leeway to respond depending on how economic conditions change.
The Research Team is part of iFAST Financial Pte Ltd.