The Unwind Policy Gets More Detailed

The Fed’s Minutes surprised many as it gave details about the balance sheet unwind. It was a smart idea to give some of the details since the FOMC has come to an agreement on the policy. Janet Yellen will have a press conference after the June meeting. Journalists and bankers can digest the new policy and create their models a few weeks in advance before the specifics are given in June. The framework of caps which last three months was explained. The question is when the unwind will start and at what level. The major banks have moved up their expectations for when the policy would start from early 2018 to September of this year. The Fed has been consistently saying it would start the unwind at the end of this year, but the banks hadn’t taken them at their word until now. Since the Fed is planning to raise rates in June and September, I think it makes sense for the Fed to start the unwind sometime between September at December. My best guess is October.

JP Morgan believes the caps will start at $4 billion per month for mortgage backed securities and $8 billion per month for treasuries. It believes the caps will rise to $16 billion per month for mortgage backed securities and $32 billion in treasuries per month by the end of next year. The timing of when the process starts doesn’t matter much unless there is an unforeseen change in the economy or market right before the process starts; then it might be delayed. This process has been discussed for 8 years ever since QE1 was instituted. It’s interesting to see how it will affect the market. The critics of the policy can be proven correct if something goes wrong or the Fed can be proven correct if nothing bad happens.

Former Fed chairman, Ben Bernanke said in May, in a CNBC interview, that the Fed is aiming to shrink the balance sheet to between $2.3 trillion and $2.8 trillion. I think Ben Bernanke is biased because he instituted QE. He doesn’t see the immediate need to unwind the balance sheet and has been a big proponent of not unwinding the whole thing. Even though he’s biased, JP Morgan’s expectation is for less of an unwind. They think the Fed will stop its unwind when the balance sheet gets to $3 trillion. I think whatever number the Fed puts on the finalization of this process will affect the bond market in the near term. However, the actual goal is meaningless because it’s expected to end in 2023. The Fed has been speaking about the unwind for years. The current guidance is much different then what was discussed in the past few years, so making a prediction for the next 6 years of policy is a fool’s game.

The most obvious problem with the chart above is that it ignores the possibility of a recession. If there is a recession in the next 6 years, the unwind will halt and the Fed will institute QE 4. When the Fed lays out the specifics of the plan in June, the market won’t have as big of a knee jerk reaction as I initially projected because the framework has been laid out. This prevention of a spike in volatility is why I said the Fed’s explanation process was smart. The only way there could be a large spike in volatility is if the Fed decided to not cut rates. Currently there’s an 87.7% chance of a rate hike in June, so it’s locked in. Since the Fed has been ignoring the latest inflation data, I wouldn’t expect a bad May labor report to affect the Fed’s decision making. The Fed wants to raise rates regardless of the latest data.

I didn’t finish my criticism of the Fed’s Minutes in the last article, so I will add some more thoughts  now. The Fed stated it expected inflation to stabilize at about 2% as PCE will increase because of tightness in the labor market. The Fed’s opinion on inflation has become faith based instead of data based. The Fed thinks the labor market is strong because of the low unemployment rate. It thinks that will increase the PCE. The reason I say it’s faith based is because inflation hasn’t increased despite the low unemployment rate. The Fed ignores the reality of the data seen in the chart below and remains on the hawkish train. The headline report was boosted in 2016 because of oil price increases. That base effect is gone so I expect the headline number to drift lower in the next few months. Core PCE inflation has been below the Fed’s goal of 2% since 2012 and shows no signs of acceleration.

The most ridiculous part of the Minutes was the discussion of valuations. The Fed stated “asset valuation pressures in some markets were notable. Although these assessments were unchanged from January’s assessment, vulnerabilities appeared to have increased for asset valuation pressures, though not by enough to warrant raising the assessment of these vulnerabilities to elevated.” The Fed is talking about the stock market when it discusses valuation pressures. I don’t understand when the Fed will consider valuation pressures to be elevated. The median price to sales ratio of the S&P 500 is at a record high. The chart below shows the Shiller PE which is a cyclically adjusted PE. It just reached a new high for the cycle. It’s a couple points away from reaching the 1929 level. The 1920s stock market bubble was the second largest in history.

Conclusion

I’ve been skeptical that the Fed would ever unwind the balance sheet ever since QE 1 was implemented. This skepticism has been the correct mindset. However, now I may finally be proven wrong in the next few months. Keep in mind that when I say I think the Fed will start the unwind in October, I’m saying that’s how I interpret their guidance at face value. I’m still skeptical of this process. A new Fed chairperson will be selected in February. If the start of the unwind goes off without a problem and the next Fed chairperson in favor of the unwind process, I will change my skepticism. However, I still will believe that the balance sheet will reach a new record high in the next recession.

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