Monday, April 11, 2022

"Only Half of the Fed’s Tightening Is Priced In."

 From Barron's, April 8:

The Federal Reserve is about to start shrinking its massive balance sheet. Officials say the process will run in the background, but it probably won’t. Investors should brace for an extended period of uncertainty and volatility.

When the central bank released minutes this past week from its March meeting, it suggested that, in May, it would begin unwinding some of the trillions of dollars in pandemic bond purchases it made over the past two years. That would be lightning-fast, given that quantitative easing just ended. The last time the Fed conducted quantitative tightening, or QT, it waited two years after interest-rate liftoff to shrink its balance sheet. Its newly suggested plan would amount to double policy tightening—half of which investors might be missing.

We know that policy makers would have raised rates by a half-point in March had Russia not invaded Ukraine, and the meeting minutes and recent Fedspeak suggest that many officials favor at least one 0.5% increase at future meetings. Traders are pricing in 80% odds of a half-point rise in May and a 50% chance of another in June, according to CME data.

But QT is not even close to being priced into markets, says Peter Boockvar, chief investment officer at Bleakley Advisory Group....

.... It’s much trickier on the mortgage-backed securities side. Part of the problem: As rates rise, prepayments fall. That lengthens the duration of the Fed’s MBS holdings, limiting the short-term natural runoff. In November 2021, the conditional prepayment rate was roughly 30%, data from S&P Global show. If prepayments slow to a 10% rate—as they did at the peak of the 2017-19 tightening cycle—MBS runoff would average about $20 billion per month, says Jefferies chief economist Aneta Markowska. That is well below the $35 billion cap the Federal Reserve has signaled, and it means that it would have to sell roughly $15 billion in mortgage-backed securities a month to meet its target....

....MUCH MORE

If interested see also April 7's: 

Société Générale's Albert Edwards: The Fed Can't Raise Fed Funds More Than 1% Without Being Forced To Reverse

In the post immediately below: Class War: Fed Governor Lael Brainard On "Variation in the Inflation Experiences of Households", I chose to focus on the hugely disparate impact of inflation on high and low income earners. However, in the same speech Governor Brainard addressed the Fed's balance sheet by saying, among other things:

"Against that backdrop, I will turn to policy. It is of paramount importance to get inflation down. Accordingly, the Committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting. Given that the recovery has been considerably stronger and faster than in the previous cycle, I expect the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19. The reduction in the balance sheet will contribute to monetary policy tightening over and above the expected increases in the policy rate reflected in market pricing and the Committee's Summary of Economic Projections. I expect the combined effect of rate increases and balance sheet reduction to bring the stance of policy to a more neutral position later this year, with the full extent of additional tightening over time dependent on how the outlook for inflation and employment evolves."

Brainard is the most dovish of the Governors, and for her to be talking like this the Board has to be very concerned they've let inflation run too wild. The unwinding of the balance sheet is the more powerful of the two tools the Fed is using, in particular the effect of letting Agency paper run off on mortgage rates, which have already almost doubled off the recent record lows. The slowdown in the household furnishings sector will be one indicator to bear in mind, and again, it is already anticipating the balance sheet moves that won't even begin until next month.

All that being said, here's more on the short rates that are directly under the Fed's control.
We join our program, already in progress at the point Mr. Edwards comes on the scene.....