Fed Bal­ance Sheet Pol­icy may Lead to More Eas­ing

The Economic Times - - Money -

The Fed­eral Re­serve has raised in­ter­est rates four times since De­cem­ber 2015 and fi­nan­cial con­di­tions have eased. That is the op­po­site of what Fed pol­icy mak­ers had hoped would hap­pen as they tight­ened mon­e­tary pol­icy. Now, cen­tral bankers are talk­ing about tak­ing the next step and shrink­ing the Fed’s $4.5 tril­lion bal­ance sheet by not rein­vest­ing the pro­ceeds of ma­tur­ing bonds into new se­cu­ri­ties.

Surely that will cause long-term yields to rise and fi­nan­cial con­di­tions to fi­nally tighten, right? Maybe not. The struc­ture of the bond mar­ket th­ese days is such that there’s a good chance con­di­tions will con­tinue to loosen, fur­ther un­der­pin­ning de­mand for riskier as­sets rang­ing from eq­ui­ties to high-yield debt to emerg­ing­mar­ket cur­ren­cies.

To un­der­stand why, first con­sider that in­sti­tu­tions that needed very high qual­ity se­cu­ri­ties to com­ply with new reg­u­la­tions de­signed to make the fi­nan­cial sys­tem safer have been some­what crowded out by the Fed’s pur­chas- es. They will now have the op­por­tu­nity to buy Trea­suries and the re­sult­ing de­mand should help con­tain long-term yields. At the same time, of­fi­cials such as New York Fed Pres­i­dent William Dud­ley have hinted there will be a pause in rate hikes dur­ing the ini­tial stages of bal­ance-sheet nor­mal­i­sa­tion, which should also help sup­port the mar­ket.

Then there are more tech­ni­cal rea­sons to be­lieve that fi­nan­cial con­di­tions will con­tinue to be rel­a­tively loose. Some strate­gists and in­vestors are un­der the im­pres­sion that in the ab­sence of Fed pur­chases, the Trea­sury De­part­ment will have to in­crease is­suance of longer-term debt if it wants to meet its goal of rais­ing the av­er­age ma­tu­ri­ties. The as­sumed re­sult from all this new debt would be a rise in longer-term bond yields. The prob­lem with that as­sump­tion is that the Fed’s bal­ance sheet as­sets and Trea­sury is­suance have cur­rently about the same amount of du­ra­tion risk. Longer-term yields could there­fore stay range bound while the Fed’s bal­ance sheet nor­mal­i­sa­tion plan al­lows for a pause in rate hikes so the econ­omy can ad­just. The com­bi­na­tion of th­ese two factors is a de facto “eas­ing” pol­icy.

Then con­sider that po­si­tion­ing in Trea­sury fu­tures is dom­i­nated by two ex­treme views: bets against short-term Trea­suries on the no- tion that Fed rate in­creases will con­tinue in a grad­ual fash­ion and bets on gains in longer-term Trea­suries on the no­tion that bal­ance sheet nor­mal­i­sa­tion won’t cause a ma­jor dis­rup­tion in that part of the mar­ket. It’s not hard to imag­ine that short-term notes could ben­e­fit as bear­ish po­si­tions are un­wound, cre­at­ing in­her­ent de­mand. This po­ten­tial shift in po­si­tion­ing would put pres­sure on the yield curve to steepen, re­vers­ing the dom­i­nant flat­ten­ing trend that has been has been in place since late 2013.

A steeper yield curve would only serve to boost de­mand from for­eign cen­tral banks, help­ing to con­tain any rise in yields. Re­cent Trea­sury De­part­ment debt auc­tions have seen an in­crease in bid-to-cover ra­tios for two- and five-year Trea­suries and more par­tic­i­pa­tion by “in­di­rect” bid­ders, which are gen­er­ally thought to be for­eign of­fi­cial in­sti­tu­tions. As a re­sult, for­eign cen­tral bank hold­ings of fiveyear Trea­suries have turned pos­i­tive since the start of 2017 on a rolling monthly ba­sis.

Bal­ance sheet nor­mal­i­sa­tion may also cause cor­re­la­tions among global bond yields to be­come even less so. As men­tioned ear­lier, long-term in­ter­est rates may stay in a range be­cause of lim­ited risk stem­ming from a shrink­ing bal­ance sheet. That may con­tain in­ter­est rate volatil­ity and be­cause of lack of move­ment, cor­re­la­tion could fall. This is a dif­fer­ent sit­u­a­tion than dur­ing the “ta­per tantrum” in 2013, when yield cor­re­la­tions were very high, and why a sell-off in Trea­suries at the time spilled over into other bond mar­kets around the world. Cor­re­la­tions have since fallen as cen­tral bank bal­ance sheets ex­panded. It can even be said that the Bank of Ja­pan’s tight con­trol over that na­tion’s yield curve is con­tribut­ing to the low volatil­ity in bond mar­kets world­wide.

Tak­ing all th­ese factors into con­sid­er­a­tion, it’s easy to see how the Fed’s bal­ance sheet nor­mal­i­sa­tion plan might not be as dis­rup­tive as some sug­gest. The big risk is that fi­nan­cial con­di­tions loosen to an ex­treme and are fol­lowed by a broad stock mar­ket cor­rec­tion. Un­til that hap­pens, though, ex­pect Fed pol­icy tight­en­ing to be­have more like an eas­ing.

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