Ahead of this week's main central bank event, in which Wall Street consensus broadly expects the Fed to officially announce balance sheet shrinkage in this week's FOMC meeting, with the actual process set to begin in October, here is a less than bullish preview of what may happen from Bloomberg commentator Garfield Reynolds, who covers FX, bonds and commodities.
Fed’s Pruning Will Send Yields Higher for Longer: Macro View
The Federal Reserve’s plan to trim its balance sheet is likely to begin with barely a whimper for markets, but there’s plenty of potential for it to end with a bang as the three-decade bull run for bonds gets killed off.
Fed Chair Janet Yellen has been very clear that she and the other FOMC members are keen to reduce the central bank’s asset holdings while making the beginning of the end of QE as harmless as possible to broader markets.
Expectations Yellen will announce the plan to trim the Fed’s balance sheet this week make the meeting that starts Wednesday a potentially key pivot point for markets that have become accustomed to endless, bottomless central bank largess.
While the Fed’s balance sheet is now only the third-largest in the G-10 (currency effects and extended purchases have allowed the ECB and BOJ to move past it), it does oversee the world’s reserve currency for one thing, and for another it will be the first of the majors to actively trim assets.
And that largess mentioned above has already shown signs of fading.
- The BOJ is tapering by stealth and the ECB is approaching its own tapering as both banks face practical constraints on the assets they can buy.
- The combined balance sheets of the Fed, ECB, BOJ and BOE have flattened out over the past six months when viewed relative to their combined economies. They stood at an unprecedented and impressive 37% of their GDP at the end of August, but the pace of increase has slowed to a crawl and the Fed’s move may signal this is the peak.
The surge in central bank assets coincided with the collapse in the term premium - a gauge that seeks to measure the extra compensation investors need to own long-term Treasuries - which hasn’t been above zero since January 2016.
Officials at the Fed and the Reserve Bank of Australia are among those who have pointed to the key role term premiums play in guiding nominal yields.
Reduced central bank balance sheets should put a floor under nominal yields, and while it’s unlikely to lead to any sudden surges, the gradual removal of the gravitational pull of QE makes the upside risk for yields prone to exponential acceleration.
The whole set-up is reminiscent of the 2000 millennium bug anxieties. For all the dire warnings of IT Armageddon, the change came and went without much fuss, but the dot-com bubble that we all knew had become massively overblown did eventually pop. And the fact that it burst later rather than on cue made the collapse all the more spectacular.
Market expectations for G10 rate hikes are already at the highest since 2014 (see chart here). The Fed’s balance sheet actions may be the catalyst for investors to register that global policy tightening is accelerating.