Fed is Rethinking Its Balance Sheet Unwind: Expect Lower LT Rates, Higher Gold

The Fed is unlikely to keep its balance sheet reduction plan on target. There are significant consequences.

Bloomberg has a significant story that matches my Fed balance sheet reduction hypothesis from the beginning.

Please consider Fed's Big Balance-Sheet Unwind Could Be Coming to an Early End.

An unexpected rise in overnight interest rates is pulling forward a key debate among U.S. central bankers over how much liquidity they should keep in the financial system. The outcome will determine the ultimate size of the balance sheet, which they are slowly winding down, with key implications for U.S. monetary policy.

One consequence was visible on Wednesday. The Fed raised the target range for its benchmark rate by a quarter point to 1.75 percent to 2 percent, but only increased the rate it pays banks on cash held with it overnight to 1.95 percent. The step was designed to keep the federal funds rate from rising above the target range. Previously, the Fed set the rate of interest on reserves at the top of the target range.

Since beginning the shrinking process in October, the Fed has trimmed its bond portfolio by around $150 billion to $4.3 trillion, while remaining vague on how small it could become. Officials have said that, as they drain cash from the system by shrinking the balance sheet, a rise in the federal funds rate within their target range would be an important sign that liquidity is becoming scarce.

“We are looking carefully at that, and the truth is, we don’t know with any precision,” Fed Chairman Jerome Powell told reporters on Wednesday when asked about the increase. “Really, no one does. You can’t run experiments with one effect and not the other.” “We’re just going to have to be watching and learning. And, frankly, we don’t have to know today," he added.

Mark Cabana, a Bank of America rates strategist, said in a report published June 5 that Fed officials may stop draining liquidity from the system in late 2019 or early 2020, leaving $1 trillion of cash on bank balance sheets. Cabana, who from 2007 to 2015 worked in the New York Fed’s markets group responsible for managing the balance sheet, even sees a risk that the unwind ends this year.

If Cabana is correct, and I believe he is, there are at least four significant consequences.

Four Consequences to Fed Delays in Balance Sheet Reduction

  • Downward pressure on interest rates : If Fed officials do opt for a bigger balance sheet and decide to continue telling banks to prioritize cash over Treasuries, it may mean lower long-term interest rates, according to Seth Carpenter, the New York-based chief U.S. economist at UBS Securities. “If reserves are scarce right now, and if the Fed does stop unwinding its balance sheet, the market is going to react to that, a lot,” said Carpenter, a former Fed economist. “Everyone anticipates a certain amount of extra Treasury supply coming to the market, and this would tell people, ‘Nope, it’s going to be less than you thought.”’
  • Upward pressure on gold
  • Downward pressure on the US dollar
  • More free money to banks at taxpayer expense

Fed Rethink Hints

  • The Fed increased interest it pays on excess reserves 20 basis points on Wednesday rather than the expected 25 basis points.
  • The Fed significantly altered its FOMC statement about future policy.

Moreover, the Fed has to be at least a bit worried about housing.

I discussed those ideas, in detail, on Wednesday.

Related Discussion

  1. Fed Hikes Again, Modifies Accommodation Language, Plans on 2 More Hikes in 2018
  2. Mortgage Rates Move Higher on Fed Dot Plot Projections
  3. Free Money Calculation: Fed Will Give $36.93 Billion of Taxpayer Money to Banks

Gold is highly likely to be a benficiary of this set of actions.

Mike "Mish" Shedlock

Comments (13)
No. 1-13
LawrenceBird
LawrenceBird

So which is it.. the economy is booming or all these numbers (like retail sales today) are just 'fake numbers' ? If the former, I find it hard to believe that the economy can't handle funds at 4% (or higher) given the past history of the 80s and 90s and even early 00s.. If the latter, when will there be an investigation and policy makers admit it has all been smoke and mirrors for many years? The choices are orthogonal as there really is no middle ground on this one.

Ambrose_Bierce
Ambrose_Bierce

Corporates are shrugging off balance sheet reduction that should mean full steam ahead, if anything the FED will let more bonds rolloff, just keep your eye on high yield, (making new highs) and the yield curve, which can flatten even as rates rise. The blowback from dollar denominated debt in the EM is the problem, the dollar is the problem, and as Armstrong says a rising dollar is the worst case outcome. If the dollar rises the Fed might pause, but its likely the tide has already turned and the lack of any coordinated policy between 45 and the Fed just invites the question. LIBOR is on fire, and should make 5% within a year, which is by my measure will be the end of this farce.

gio1
gio1

and please tell me the fed is independent....

thimk
thimk

well i guess its time to consult the fed's majic 8 ball

Roger_Ramjet
Roger_Ramjet

It has long been my view that the Fed’s biggest challenge has nothing to do with inflation, full employment or asset bubbles, but rather maximizing bank profits through its IOER program. As Mish pointed out, it’s foolish to believe that this is an effective tool to control lending by large banks. That’s the necessary narrative sold to congress and the public to allow massive payments to the large banks.

So it is no surprise that the Fed is already discussing pulling back on reducing its balance sheet. Call me a cynic (how could you not be after the last 10 years of monetary policy), but the balancing act that I see is between trying to normalize monetary policy while not (materially) impacting bank earnings.