The following article is courtesy of AETOS analyst Ryan Chen. Part I of the report can be seen here.
Ryan Chen
Reality not as silky as ideal
As early as the end of 2018, there was sign that the Fed was shifting to dovish monetary policy. Fed Chairman Powell said, in a speech at the end of November 2018, that interest rates were “just below” the neutral range, as opposed to a former statement that “it is a long way before the neutral interest rates.” The subtle changes in his rhetoric, however, elevated concern in the market. Institutional investment banks almost immediately recognized that the Fed’s tightening monetary policy was coming to an end. At that time, the prevailing view among institutional analysts was that the Fed would raise rates two more times in 2019 following the one in December 2018, and that this would mark the end of the interest-rate rise cycle.
The truth, however, is that reality can never be as silky as ideal.
Since January 2019, almost all of the Fed’s policymakers have given speeches or published papers that were more cautious and dovish than their original positions. Among them there are former New York Federal Reserve Bank President Williams, who previously was a monetary hawk, advocating that “slowdown is the new normal, and QE and negative interest rates will be considered if necessary”; Cleveland Federal Reserve Bank President Mester, whose argument was that “if inflation doesn’t pick up, the Fed could stop raising interest rates this year,” and Boston Federal Reserve Bank President Rosengren, who said, “Whether more rate hikes are needed depends on the economy.”
Market expectations of the number of the Fed’s rate hikes for this year and next have cooled sharply. A look at the probability charts reflected by the CME FedWatch tool shows that the market had all but downplayed the likelihood of a Fed rate hike in 2019 on the eve of the Fed’s March meeting. The boldest analysts even pointed out that the Fed’s next move would not be a rate hike but would instead be a cut.
Expectation of an interest rate cut may sound like aggressive speculation, but the suspension of interest rate increases has become a consensus among the Fed and the market. At the Fed’s March meeting, policymakers firmly put the brakes on tightening. Most fed officials expected the number of rate hikes to fall from two to zero in 2019 and at most once in 2020. They lowered GDP and inflation expectations for this year and next, and raised unemployment expectations. Thus, a plan was made to halve the scale of Treasury bond reduction from May 2019 to the end of September, and plans were made to continue reducing its holdings of agency bonds and mortgage-backed securities (MBS) so as to align with its long-term goal of primarily owning U.S. bonds.
The threshold for dovish modification of the Fed funds rate is undoubtedly higher than that of the conventional monetary policy instrument, and the signal of a shift in monetary policy is stronger.
By the time QE stopped at the end of 2014, the Fed’s balance sheet had reached a frightening $4.5 trillion. According to the Fed’s balance sheet released on March 7, 2019, Fed had cut $290 billion in Treasury bonds, $163 billion in MBS and $48 billion in other assets since October 2017, when its downsizing was rolled out. Such asset reductions are unprecedented in its history.
The Fed’s position is clearly one in which it will end its 24-month balance-sheet “squeeze plans” at the end of the third quarter. Certainly, this represents an early time node in all the mainstream market expectations. The result, in other words, is that the Fed’s balance sheet will be “fuller” than previously expected.
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