Quantitative Tightening Begins, Beige Book Mixed, Brainerd Makes Hawkish Comments
Well, it is the end of an era. For well over a decade now the Federal Reserve has been expanding its balance sheet, save the abortive effort to tighten in 2017-2018. On Wednesday, the Federal Reserve started letting assets mature from its historically high $9 trillion balance sheet. The exact outcome of the massive change in Fed policy is still unknown currently, and there’s frankly not a lot of useful historical analogs. Wells Fargo Investment Institute and many other analysts suspect that the sea change in Fed policy will be a headwind for stocks. Generally, it will reduce liquidity in markets. The purpose of quantitative easing is for the Fed to purchase low-risk assets and thus incentivize investors to increase their appetite for relatively riskier assets. Quantitative tightening is the opposite.
Janet Yellen once described quantitative tightening as “watching paint dry.” However, the inevitable effect of pulling large amounts of liquidity out of markets will likely be some degree of multiple compression. Of course, this could be offset by other positive developments. The Federal Reserve will be reducing its holdings of mortgage-backed securities and treasuries by $47.5 billion a month for the first three months of the process.
Then, the monthly reduction will increase to $95 billion a month. This pace is significantly more aggressive than what transpired in 2017. According to Wells Fargo Investment Institute, the Fed will have reduced its balance sheet by $1.5 trillion by the end of next year and this will be equivalent to about 75 bps or 100 bps in additional tightening. All else being equal, this should put upward pressure on real yields and will be a potential headwind for risk assets.
Vice Chair Lael Brainerd is considered one of the more dovish members of the FOMC. However, those expecting dovish comments from her were sorely disappointed on Thursday. After Atlanta Fed President Raphael Bostic suggested the Fed could become data-dependent after two 50 bps hikes (one of which has already occurred), the doves again gained hope that the Fed might revert to a more accommodative posture.
The FOMC will meet on June 14th and 15th. The yield on the 10-yr closed Friday at 2.743%. Quantitative tightening begins in June as well. Brainerd said that the Fed will of course remain data-dependent, but that she found it incredibly unlikely that the Fed would cease its current aggressive hiking momentum before sustained progress on inflation was observed. Rather than imply a 25-bps hike could materialize in the face of data, she suggested that another 50 bps hike might be required unless she saw demand cooling. “Right now, it’s very hard to see the case for a pause,” said Brainerd. She noted there was “a lot of work” to do before the Fed got closer to its 2% inflation target. Brainerd threw cold water on the idea that the Fed would pause in September and her view is likely closer to Chairman Powell’s.
The Fed’s Beige Book showed that the economy was still growing at a “slight to modest pace” but that many firms were having trouble with both higher prices and a tight labor market. Companies are clearly passing price increases of inputs along to consumers and sometimes consumers are pushing back. Some districts saw customers taking efforts to ease pressure on their wallets, such as switching to second-rate brands or buying half a gallon of milk instead of a full gallon. Also, across Fed districts there were also reports of increasing automation, offers of higher compensation, and greater job flexibility to address difficulty in finding workers. Please see a great chart put together by Tireless Ken and our data science team on some specifics of the recent Beige Book below.
The FOMC will meet on June 14th and 15th. The yield on the 10-yr yield closed at 2.95% and quantitative tightening has now officially begun. All eyes are on inflation, but our research team has recently done some fantastic and thorough work showing why our base case is that inflation moderates more than consensus may currently expect.
