Market Digests Prospect of Quantitative Tightening, Biden Passes Inflation Baton to Powell, Digital Dollar Report Released
Market Digests Prospect of Quantitative Tightening, Biden Passes Inflation Baton to Powell, Digital Dollar Report Released
Markets sold off intensely this week and commentators seem to have a lot of uncertainty about the approaching prospect of quantitative tightening. Remember QE Infinity? It appears the Fed is seriously approaching contracting its balance sheet at the same time as raising rates, or soon after. Markets have historical precedent to be apprehensive given this is the end of the most accommodative period in the history of the US Central Bank.
The most recent large-scale effort by the Federal Reserve to shrink the balance sheet happened at the end of Janet Yellen’s tenure as Chairman and at the beginning of Powell’s first-term, from October 2017 to September 2019. The Fed’s balance sheet was about half the size then as it is now. The shrinking that occurred was only about 16% of the total balance sheet and equalled about $710 billion. The effort ended unsuccessfully when repo market rates spiked. For a market awash in liquidity and also copious significant risks, this prodigious change will inevitably cause volatility.
While Powell left the timing open at his most recent testimony, pay attention to the comments on the issue the next time the minutes are released to see what the discussion entailed. The next FOMC meeting will occur next week from January 25th-26th. Needless to say, given the precarious state of markets this is a critical Fed meeting that could significantly move markets even though most commentators expect the Fed to try its best to make the meeting a non-event.
Bill Ackman made headlines last week by calling for the Fed to contemplate a 50 bps rate-hike. We see this as unlikely and believe the Fed board would probably prefer to avoid this given that Omicron is definitely reducing movement and this will inevitably show up in economic data. This would be the first rate-hike of that magnitude in over two decades, since 2000. However, from the minutes it appears the Fed would currently prefer to accomplish tightening through quantitative tightening rather than surprising markets on rates, as uncertain as that process may be.
One of the main uncertainties surrounds whether the Fed would just let securities ‘runoff’ when they expire or whether they’d take the more aggressive option of actually selling securities in the open-market. Given the composition of maturities on the balance sheet and given how quickly it expanded, letting securities runoff seems like the more likely and low-risk option to us.
Christopher Waller suggested in a speech he’d like to see the balance sheet down to about 20% of GDP down from current levels of around 36%. If you assumed a 5% rate of GDP growth over the next three years, which could end up being generous, this would mean the Fed would have to offload about $3.4 trillion worth of securities.
President Biden addressed inflation on Wednesday and acknowledged it was becoming a major concern for many Americans. While he said his administration would take great efforts to prevent price rises caused by things like declining competition in more consolidated industries that the primary onus was on the Federal Reserve. He mentioned he thought the Fed had begun taking appropriate action to curb rising prices.
The Federal Reserve released a long-awaited report on the prospect of a ‘digital dollar,’ or the US version of a Centrally-Banked Digital Currency (USDC). For those who were expecting a conclusive position from the Federal Reserve, you may be disappointed. However, the findings of the report were pretty profound and it is definitely worth a read. You can find it here. The Fed essentially mentions that a digital dollar could significantly alter the payments and banking system, which are more antiquated than even some third-world nations, in positive ways by increasing speed and efficiency. The main concerns listed in the report are that design would have to preserve financial and monetary stability, address privacy issues and effectively preventing illegal activity. Vice Chair Lael Brainerd has been the biggest advocate on the Board for a digital dollar. The tapering of monthly purchases of $80 bn of Treasuries and $40 bn of MBS began in November, and was accelerated in December. The Fed is currently purchasing $60 billion of securities a month, half of the original level of purchases. The Fed will be done with asset purchases in mid-March 2022 at this pace. The benchmark yield on the 10-Year Yield was 1.77%, down from its 2-year high earlier in the week.
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