The just-passed May meeting of the US central bank’s Federal Open Market Committee (FOMC) announced to increase the benchmark rate by a half percentage point, in line with market expectations.
Over the past two months, most discussions among investors have centred around the possibility of the US and European central banks expediting and stepping up their monetary policy tightening.
Although the answer to both questions is a resounding Yes, the European Central Bank’s (ECB) tightening schedule will lag that of the Federal Reserve owing to it bearing more brunt of the Ukraine-Russia war than the US. The ECB has also been non-committal about the rigour with which it will tighten its monetary policy due to the economic uncertainty of the region – the central bank would probably not want to get ahead of itself to give it more room for manoeuvre at a later stage.
As for the US, in view of elevated inflation and tight labour market conditions, the Fed will begin reducing the size of its balance sheet (also known as balance sheet runoff, which is the opposite of quantitative easing) while increasing the interest rate. The post-meeting statement of May showed that the Fed will begin the balance sheet runoff in June at an initial pace of $47.5 billion, stepping up over three months to $95 billion. With the Fed’s balance sheet currently standing at around $9 trillion, the process of normalisation will shrink the size of its balance sheet by as much as 13% over the coming year, a pace that surpasses the balance sheet reduction exercise that took place in 2018 – 2019 in both percentage and absolute terms.
It is expected that another half percentage rate hike will be seen in June. In fact, the March meeting detail showed that if it hadn’t been for the uncertainties brought about by the Ukraine-Russia war, it would have been a 50bp increase in the interest rate that the FOMC proceeded with in March, instead of a 25bp rise.
The FOMC estimated that the Federal funds rate will reach 1.6% – 2.4% by the end of this year – which is significantly higher than both the previous forecast of 0.6% – 0.9% and the current level of 0.3%, and may even climb to 2.4% – 3.1% by the end of next year.
In addition to the rate hike and balance sheet runoff, the FOMC generally agreed on the gradual sales of Mortgage-Backed Security (MBS) in order to maintain a neutral stance in monetary policy without favouring any particular sector. Officials have also expressed the plan to hold primarily Treasury securities in the Fed’s portfolio.
As of now, the global markets have only seen the Fed carry out balance sheet runoff once in the past, which we think can serve as a point of reference for what is to come. Back then, the Fed began tightening with rate hikes, followed by balance sheet runoff after the Fed funds rate reached 1.25%. In contrast, the central bank is on course to trim its asset holdings much earlier in the tightening process this time.
The previous tightening cycle wrapped up after 225bp of cumulative interest rate hikes and around 15% of reduction in the Fed’s balance sheet thanks to the economy stabilising with the inflation rate settling at about 2%; any further tightening would risk putting deflationary pressure on the economy. But inflation levels today have outstripped considerably what we saw the last time around, meaning that the likelihood of deflation risk being a factor that stops the Fed from continuing to reduce its balance sheet is low. But if the central bank does take a pause in normalising its balance sheet and in increasing interest rates, it will more likely be due to a recession.
There are several aspects of balance sheet runoff and interest rate hikes this time round that warrant investors’ attention.
First, the current round of tightening measures comes in greater intensity, whereby the Fed has set out to normalise its balance sheet and lift interest rates almost simultaneously, hence broadening the associated impact on the US economy and stock market.
Second, the most curious phenomenon during the last tightening cycle was the decline in the 10-year Treasury yield, to most investors’ surprise, alongside the shrinking of the Fed’s balance sheet, when they had been forecasted to rise instead. Indeed the increase in the supply of treasury notes resulting from balance sheet runoff should push yields up, but the coexistence of the increased supply and interest rate hikes were signalling a firm determination from the Fed to tighten monetary policy, which in turn suppressed long-term inflation expectation, leading to the 10-year Treasury yield to drop. In the past two years, although the 10-year Treasury yield has largely risen, albeit not without swings, investors should pay close attention to whether the Fed’s dual-pronged tightening strategy will lead to a repeat of what took place in the last cycle.
Finally, the Fed will be selling its holdings of MBS gradually, so it’s worth noting how the current heated US real estate market will be responding to such a move.
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