The Fed looks set to start adding to its balance sheet again: How will the bank ever exit without crashing the bond market?
I think the Federal Reserve is setting up investors for a significant change in policy to be announced after tomorrow’s, Wednesday, December 12, meeting of the Fed’s Open Market Committee.
The new plan would resume the rapid growth of the Fed’s balance sheet and push it to $3 trillion sometime in 2013.
And that just makes the big problem facing the Federal Reserve and the U.S. economy even bigger. After expanding its balance sheet by buying what will soon be an additional $2 trillion in debt to help stave off the worst effects of the global financial crisis and then to support a stumbling U.S. economy, how does the Fed shrink its balance sheet back to something like normal size without crashing the U.S. and global economies?
In other words Wednesday’s Fed meeting has huge implications for bonds, inflation, interest rates and how you structure your portfolio.
The Federal Reserve’s Operation Twist is scheduled to expire in December 2012. That program to swap about $270 billion in short-term Treasuries for longer-term, five- to seven- year debt to lower longer-term interest rates in order to support the recovery of the U.S. housing sector and to stimulate U.S. economic growth is almost certain to end with the year.
But Ben Bernanke and company are also almost certain to replace Operation Twist with a new, more aggressive program of quantitative easing. The Fed is clearly worried that the debate over the fiscal cliff alone or the actual expiration of all of the Bush tax cuts, the Social Security tax reduction, extended unemployment benefits, and the automatic budget cuts imposed by the debt ceiling deal will be enough to slow the U.S. economy and could even send the United States back into recession.
The new program, recent speeches by Federal Reserve governors and basic math argue, will be an out and out plan to buy five- to seven-year Treasuries. That would continue the thrust of Operation Twist but get around a big problem that the Fed now faces. It has become increasingly hard for the Federal Reserve to sell its short-term holdings of Treasuries and to buy medium-term debt to replace them because the Fed has effectively sold most of its short-term holdings. Since September 2011 the Federal Reserve has replaced $667 billion of short-term Treasuries on its balance sheet with medium-term debt. The Fed just doesn’t have much more short-term Treasuries to sell to balance its purchase of medium-term debt.
The new program will require the further expansion of the Federal Reserve’s already massively large balance sheet of $2.85 trillion as of November 21, 2012. That level has been relatively stable since June 2011.
But the new plan would change that. Read more
No secret what the big events that investors will hang on this week: The Federal Reserve’s Open Market Committee meets on Wednesday, August 1, and the European Central Bank meets on Thursday, August 2.
Will the Fed launch a new program of debt buying—a third round of quantitative easing? Will the European Central Bank cut its benchmark interest rate a third time—to 0.5%? Will it re-launch its program of buying Italian and Spanish government bonds? Will there be another big loan offering to European banks?
As hard as predicting what the central banks will do is, it’s just as critical and just as difficult to predict how the financial markets will react to action or non-action.
I still think that the most likely scenario this week is for the Federal Reserve to do nothing—but to tee up action for the central bank’s September 13 meeting with a statement that stresses the worryingly weak growth indicators for the U.S. economy and the very low rate of inflation in the United States. I think the Fed remains reluctant to act before the European Central Bank does—even if only by a day. The weakness is the global economy is largely a function of the euro debt crisis, the Fed has intimated, and I think the U.S. central bank would like its European counterpart to show some leadership right now.
ECB president Marie Draghi spent much of last week consulting with European leaders—Merkel and Hollande—and with Jenns Weidmann, president of the Bundesbank—and it would be a huge surprise if after that public consultation the European Central Bank did nothing. The question is how far Draghi will go—I think the odds favor another interest rate cut and a resumption of bond buying—with lesser odds in favor of a new round of money for Europe’s banks.
If events actually come out somewhere near my scenario, what will financial markets do? Read more
Talk about fine-tuning. The changes in wording—let alone any shift in policy—made in today’s 12:30 statement from the Federal Reserve’s Open Market Committee are miniscule.
So, for example, today the Fed said “Despite some signs of improvement, the housing sector remains depressed…” while in its last statement on March 13 it noted that “The housing sector remains depressed…”
Inflation has picked up somewhat, according to today’s statement, but the increase is expected to be temporary. Last month, the Fed said inflation was subdued.
And here’s my favorite big change: In March the Fed said it expects moderate growth over coming quarters but today it said it expects growth to remain moderate over coming quarters and then to pick up gradually.
In short, nothing here to send those betting on Federal Reserve easing off to buy gold and nothing to drive those worried about growth kicking off higher inflation to sell their Treasuries.
The Federal Reserve did confirm its promise to keep rates at 0% to 0.25% through the end of 2014.
Federal Reserve Chairman Ben Bernanke is scheduled to give his regular post-meeting press conference today at 2:15.
Masochists can watch it live on the Federal Reserve website http://www.federalreserve.gov/ .
Stocks liked Fed chairman Ben Bernanke’s speech yesterday that emphasized the Federal Reserve’s doubts about the strength of the recovery in the job market. But the gold market liked it even more. The SPDR Gold Shares climbed to $164.40 yesterday from $161.53 on Friday, March 23. That was a 1.8% gain for the gold bullion ETF.
Bernanke chose a glass-half-empty approach to recent job gains in his speech to the National Association of Business Economists. The rapid drop in the unemployment rate in the last six months to 8.3% from 9.1%, he said, may reflect a one-time bounce reversing the job cuts of 2008 and 2009. “To the extent that this reversal has been completed,” Bernanke said, “further significant improvements in the unemployment rate will probably require a more rapid expansion from consumers and businesses, a process that can be supported by continued accommodative policies.”
In other words the Fed isn’t even vaguely thinking of rescinding its promise to keep interest rates at current extraordinarily low levels through the end of 2014. And the possibility of another round of quantitative easing remains on the table.
The stock market, accurately, heard the sounds of printing presses churning out dollar bills in Bernanke’s remarks. Stocks rallied because increases in the money supply support faster economic growth (in the short-run anyway and who worries about the long-run on Wall Street right now?) and because lower interest rates make stocks look even better against bonds. (The S&P 500 stocks currently yield 1.86%. That’s more than the 1.02% yield on the 5-year Treasury note and not far behind the 2.18% yield on the 10-year Treasury.)
So too did the gold market where the sound of printing presses argues for a falling dollar (good for gold) and an eventual increase in inflation (good for gold).
Right now it looks like the SPDR Gold Shares ended their 10% or so correction from their February 28 intraday high at $174 to a bottom at $158 and have, with yesterday’s move broken through resistance to start a new rally.
Potentially anyway. Read more
Are we headed back to the days of ‘risk off’?
It certainly looked like it last week with the market worried about slowing growth in Europe and about a hard landing in China.
The most striking indicator to me was the reversal in the Treasury market. After climbing for the week that ended on Friday, March 16, in the aftermath of the Fed’s slightly more positive take on the U.S. economy, Treasury yields fell this past week as investors looking for safety bid up prices. (Yields fall on Treasuries as prices rise.)
Yields on the 10-year U.S. Treasury notes fell the most since January, dropping from last week’s five-month highs. Yields fell 0.06 percentage points to 2.23% for the week that ended on March 23. That almost exactly wiped out the increase in yields of 0.27 percentage points in the week that ended on March 16.
The risk-off trade that alternated with period of risk-on trading in 2011 is characterized by flight to dollar and yen denominated assets, selling of emerging market currencies, bonds, and equities, and relative outperformance by “safe” markets such as the United States against “risky” markets such as China or Brazil.
Of course, the shift from risk-on to risk-off takes a bite out of all markets as investors in “safe” markets sell the riskier assets in those markets.
The strength of the “risk-off trend” will get a test in the upcoming week when the U.S. Treasury is scheduled to auction $99 billion in two-year to seven-year maturities.
If yields still drop even in the face of that jump in supply, it means that investors are looking for safety again and are willing to pay a big premium for it in the Treasury market. If that’s the case then I’d say risk-off is likely to last for a while.