Every Central Bank Has A Plan Until It Gets Punched In The Face

Posted on Posted in Bonds & Fixed Income

Today I would like to followup on yesterday’s post which likened the Fed’s unwinding of its balance sheet to a high wire act. The FOMC, under the leadership of Chair Janet Yellen, did as expected by not raising the Fed Funds Rate, thus maintaining 1.00 to 1.25%.

Introducing a plan to reduce its $4.5 trillion balance sheet was the focal point and we now have some quantifiable answers. The pace will be gradual at $10 billion per month ($6bn cap for treasuries and $4bn cap for mortgage securities) and incrementally increase by $9 billion ($3bn for treasuries and $4bn for mortgage securities) each 3-month interval. Most of this will be accomplished through attrition, which means that the proceeds of maturing debt will not be reinvested. At this pace and as indicated by the hypothetical schedule I have provided, it would take @ 3 1/2 years (or 42 months)to unwind at least half of its existing balance sheet. That takes us to year 2021. Bear in mind, that the Fed carried roughly $900 billion of debt before the 2008 crisis. (See table below)

 

Hypothetical of Federal Reserve’s Balance Sheet Reduction Schedule
Period Securities Periodic Totals ($billion)
Month Treasuries Mortgages Monthly Quarterly Inception
1 $6 $4 $10
2 $6 $4 $10
3 $6 $4 $10 $30 $30
4 $9 $8 $17
5 $9 $8 $17
6 $9 $8 $17 $51 $81
7 $12 $12 $24
8 $12 $12 $24
9 $12 $12 $24 $72 $153
10 $15 $16 $31
11 $15 $16 $31
12 $15 $16 $31 $93 $246
13 $18 $19 $37
14 $18 $19 $37
15 $18 $19 $37 $111 $357
16 $21 $23 $44
17 $21 $23 $44
18 $21 $23 $44 $132 $489
19 $24 $27 $51
20 $24 $27 $51
21 $24 $27 $51 $153 $642
22 $27 $31 $58
23 $27 $31 $58
24 $27 $31 $58 $174 $816
25 $30 $35 $65
26 $30 $35 $65
27 $30 $35 $65 $195 $1,011
28 $33 $39 $72
29 $33 $39 $72
30 $33 $39 $72 $216 $1,227
31 $36 $43 $79
32 $36 $43 $79
33 $36 $43 $79 $237 $1,464
34 $39 $47 $86
35 $39 $47 $86
36 $39 $47 $86 $258 $1,722
37 $42 $51 $93
38 $42 $51 $93
39 $42 $51 $93 $279 $2,001
40 $45 $55 $100
41 $45 $55 $100
42 $45 $55 $100 $300 $2,301
43 $48 $59 $107
44 $48 $59 $107
45 $48 $59 $107 $321 $2,622
46 $51 $63 $114
47 $51 $63 $114
48 $51 $63 $114 $342 $2,964

 

 

In the meanwhile, the Fed is still projecting one more 25 bps hike before year end and another 3 bumps in 2018. It has dismissed the economic impact of Hurricanes Harvey and Irma as temporary and therefore its inflation outlook remains unchanged. This posture is somewhat hawkish, given the softer GDP projections @ 2.4% in 2017, 2.1% in 2018, and 1.8% in 2020, not to mention that inflation @ 1.5% is running below its 2% target, which it admits may not be attained until 2020. If you ask me, it still sounds like a high wire balancing act.

Before I wrap this up, I only have one thing to say: “every central banker has a plan until they get punched in the face”. Why does this happen? Because, they never see the punch coming or, if they do, they are simply too slow to sidestep it. Body blows like panic-stricken bond sellers in the private sector, rapidly rising rates, an abrupt economic slowdown, or a shift in Fed policies (as POTUS Trump will be in a position to appoint up to 5 new board members, which includes position of Chair) can wear down even the most determined lender of last resort. Frankly, a lot of unforeseen things could happen between $0 and a minimum $2.3 trillion dollar balance sheet reduction, which is why I emphasize even more the importance of following the price trends of the bond market. (See chart below)

 

 

Click to enlarge

 

 

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