Weekly Market Review: Fed accelerates talk of ‘normalization’
FOMC minutes reveal an unexpected focus on unwinding its balance sheet
Interest rate hikes may not be the only form of monetary policy tightening we’ll see from the US Federal Reserve (the Fed) this year. After the release of the Federal Open Market Committee’s (FOMC) minutes last week, a new catch phrase should be gaining popularity with economists: “balance sheet normalization.”
Balance sheet normalization is a fancy term for the unwinding of the Fed’s bloated balance sheet. The minutes from the FOMC’s March meeting, released last week, revealed that the FOMC is contemplating this approach. This came as a surprise to some investors. Below, I look at how the Fed got to this point, and what balance sheet normalization could mean for the markets.
How did we get here?
Nearly a decade ago, in its policy response to the global financial crisis, the Fed not only lowered the fed funds rate from more than 5% to the 0% to 0.25% range in about 15 months, it then embarked on quantitative easing (QE). By the time it had completed three phases of QE several years later, the Fed had increased its balance sheet from approximately $800 billion to $4 trillion. At the time, many economists worried about how the Fed would unwind this bloated balance sheet — but it was a distant concern.
It’s now a more immediate concern.
Back in February, we began to see FOMC members focus their attention on balance sheet normalization. In her semiannual testimony to the Senate Banking Committee two months ago (known as the Humphrey-Hawkins testimony), Fed Chair Janet Yellen was asked about the Fed’s timetable for unwinding its balance sheet. She explained that in the coming months, the Fed will be discussing its asset reinvestment policy. She made it clear that the Fed planned to shrink its balance sheet “in an orderly way” and that it will not be used as a monetary policy tool. In terms of timing, she said it is a process that won’t begin until policy normalization is “well underway.”
In a speech in February, Boston Fed President Eric Rosengren, who has become more hawkish recently, also was questioned about balance sheet normalization. Interestingly, he suggested it could begin relatively soon. At the time, those comments seemed to be a reflection of his view that the Fed may need to tighten more than expected and of his concern that some assets are becoming frothy — in other words, they may be reaching unsustainable levels that could presage a market bubble.
New York Fed President William Dudley also spoke in February and gave some attention to balance sheet normalization. In his comments, he pointed out that “well underway” means different things to different FOMC members, and that he believed it will take a while for the Fed to begin normalizing its balance sheet. And while Chair Yellen had said the Fed does not want to use fluctuations in its balance sheet as an active tool of monetary policy management, Mr. Dudley was clear that it is a form of tightening and therefore he expected that it will extend the rate hike cycle.
Where are we now?
Fast forward to last week’s release of the March FOMC meeting minutes. In what came as a surprise to some investors, there was a lengthy discussion about when and how the Fed might normalize its balance sheet.
- There was debate about what level the Fed funds rate should be at before normalization starts, what would trigger a curtailment of the Fed’s reinvestment policy, and whether it would occur in phases or across the board. However, there seemed to be little appetite for outright selling of assets on the Fed’s balance sheet, based on the language that normalization would be “gradual and predictable.”
- While it may have seemed likely that the Fed would phase out mortgage-backed securities (MBS) first, given that they are the less-orthodox securities being held on the Fed’s balance sheet, the minutes suggest that the Fed is likely to begin phasing out both Treasuries and MBS simultaneously. However, it is unclear what portion of MBS it will be able to phase out in the near term given that the large majority of MBS the Fed holds have maturities greater than 10 years; that will clearly be dependent on the rate of pay downs that occur.
- Perhaps the most interesting finding from the minutes is the suggestion that normalization could begin this year — which is much sooner than many expected.
The Fed minutes were also noteworthy in that the Fed seemed to believe that upside risks outweighed downside risks in terms of the economic outlook for the US. However, the Fed’s economic projections remained relatively static, so fears that the Fed may raise rates four times this year seem overblown at this juncture — especially in light of the March jobs report. New job creation was low in March — although that’s not concerning at this point, as it appears related to the poor weather last month in much of the US. However, we’ll need to monitor the situation closely — especially given that the most recent estimate of first-quarter gross domestic product (GDP) growth from the Atlanta Fed GDPNow Indicator is an anemic 0.6% annualized1.
What lies ahead?
There will be clearly more debate this year — both on the state of the US economy and on the Fed’s balance sheet normalization strategy. I believe investors should consider the implications of a gradual shrinking of the Fed balance sheet. My base case is that balance sheet normalization will have a very modest impact on the Treasury and MBS markets. However, there is potential for a significant reaction as we are in uncharted waters. In particular, investors must be prepared for the possibility that unwinding the Fed’s balance sheet will have a greater impact on the stock market than rate hikes will, given the outsized impact it had during the wind up. We will certainly need to follow the situation closely. The good news is that the Fed’s plans are likely to be telegraphed well in advance of any moves.
1 Source: Federal Reserve Bank of Atlanta, as of April 7, 2017. The GDPNow Indicator seeks to forecast the growth rate of US real gross domestic product before the official estimates are released by the government.
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Global Market Strategist
Kristina Hooper is the Global Market Strategist at Invesco. She has 21 years of investment industry experience.
Prior to joining Invesco, Ms. Hooper was the US investment strategist at Allianz Global Investors. Prior to Allianz, she held positions at PIMCO Funds, UBS (formerly PaineWebber) and MetLife. She has regularly been quoted in The Wall Street Journal, The New York Times, Reuters and other financial news publications. She was featured on the cover of the January 2015 issue of Kiplinger’s magazine, and has appeared regularly on CNBC and Reuters TV.
Ms. Hooper earned a BA degree, cum laude, from Wellesley College; a J.D. from Pace University School of Law, where she was a Trustees’ Merit Scholar; an MBA in finance from New York University, Leonard N. Stern School of Business, where she was a teaching fellow in macroeconomics and organizational behavior; and a master’s degree from the Cornell University School of Industrial and Labor Relations, where she focused on labor economics.
Ms. Hooper holds the Certified Financial Planner, Chartered Alternative Investment Analyst, Certified Investment Management Analyst and Chartered Financial Consultant designations. She serves on the board of trustees of the Foundation for Financial Planning, which is the pro bono arm of the financial planning industry, and Hour Children.