June 15th, 2017

Fixed Income Note

Fed post-mortem: hawkish hike, Yellen baiting the market

·         Risk assessment in opening statement as expected, but notably the Fed no longer cited global financial conditions as something that bears close watching.

·         Despite downward drift in the ‘dots’, continues to forecast 3 hikes in total for 2017 (so one more this year); 3 in 2018, as expected. Marginal decrease in 2019 rate forecast.

·         Strong cuts in unemployment rate forecast to 4.3% this year and 4.2% in the next two years. In March each year was forecasted at 4.5%

·         GDP forecasts unchanged; 2017 inflation forecasts cut (they had to!), but 2018 and 2019 unchanged at 2.0% for both headline and core – talk about goal-seeking!

·         In the statement and in the press conference recent disappointing inflation readings were explained away, citing ‘technical’ reasons (in other words: ‘transitory’).

·         Unexpectedly announced details of balance sheet rundown today, with likely start of shrinkage to be announced in September.

·         Announced gradually increasing caps for maturing bonds that will no longer be rolled over in order to shrink the $4.5 trillion balance sheet. No target for future balance sheet size was set, but caps suggest that balance sheet will shrink by $1 trillion from 2017 through 2019.

·         Balance sheet shrinkage (Quantitative Tightening, or QT) is aggressive. UST caps start at $6 billion, increased by $6 billion each quarter to final level of $30 billion – so only maturing bonds above caps will be rolled over. Agency caps raised in $4 billion quarterly increments to $20 billion. Assuming QT starts in October, balance sheet will shrink by $420 billion next year. To put that into perspective, about $450 billion in Treasuries from the Fed’s QE holdings mature next year. Assuming a 9% run-off rate on the Fed’s Agency/MBS holdings (simply the percentage of mortgage that are prepaid, 9% estimate taken from NY Fed study), about $180 billion in Agency/MBS will mature next year. In other words, without ending reinvestments, the Fed would have rolled over about $600 billion next year, but the caps suggest $420 billion will not be rolled over, or 70%. I haven’t seen consensus estimates of the balance sheet shrinkage, but this seems quite aggressive to me.

·         Bottom line, hawkish hike. Balance sheet rundown details announced sooner than expected; no abandoning of future rate hike plans; a dovish dissent; down-playing low-flation; lack of dovish tit-bits during the press conference (no, or not much ‘we can always pause hiking’, ‘we can always stop or reverse QT’). The Fed is more preoccupied with the low headline unemployment rate than anything else out there – disappointing inflation be damned. Quite telling is that Chair Yellen was baiting the market, saying that it’s healthy for the market and the Fed to have different expectations on the economy. The market responded in kind, with a sharp flattening of the yield curve, with the 2y-10y narrowing to narrowest level since early September. Assuming no more changes in the 10y, the Fed has room for three hikes before it flips the curve… but that’s assuming no further declines in the long end yields. At the time of writing Bloomberg WIRP hasn’t updated yet… but it’s going to be bonkers as it’s markets be damned – for a change. Enjoy it while it lasts!