The Fed Tightens the Screws

The Fed is unambiguous in its attempt to tighten financial conditions. Fed Vice Chair Lael Brainard, considered one of the more dovish Fed members, put the market on notice Tuesday when she stated, “I expect the balance sheet to shrink considerably faster than the previous cycle”.

Nobody, and I mean, NOBODY, is arguing dovish monetary policy.

The commentary rattled markets with indices falling 2% since the Brainard comments. As the saying goes, ‘You can’t fight the fed’.

The S&P slipped to test its 200-day moving average, a key trend read for the markets. Bulls must establish support without the assistance of the Fed. There is no ‘Fed Put” to provide a basement, at least not at these levels.

The Fed made clear that inflation is its top priority. The question for market participants is how does the tightening impact financial conditions and equities?

Former Fed President Bill Dudley laid out the argument in a Bloomberg OpEd. Dudley opined, “it is hard to know how much the U.S. Federal Reserve will need to do to get inflation under control. But one thing is certain: To be effective, it’ll have to inflict more losses on stock and bond investors than it has so far”.

This may be a little aggressive. However, his suggestion that the Fed is comfortable seeing equity markets, a key measure of wealth for consumer spending habits, move lower is very credible. Investors need to respect this dynamic.

How does the Fed impact inflation?

The Fed purchases longer-term securities, taking it out of private hands. This drives prices artificially higher and yields lower.  Investors move on to other asset classes in search of yield. This search takes them to riskier assets (since the Fed has taken all the safe t-bills). The search and risk-taking is amplified by cheaper debt (lower mortgages, auto financing, credit cards, etc). 

The central bank bought nearly $1.5 trillion in Treasuries in March and April of 2020 to prevent a broader financial meltdown. It continued to purchase $120 billion a month in treasuries and mortgage-backed securities (MBS) until last fall. It was still buying assets last month.

Its balance sheet has ballooned to over $9 trillion from approximately $4.5 trillion at the start of the pandemic. The Fed owns $5.76 trillion in treasuries, approximately 24% of the market, and $2.72 trillion in MBS, approximately 31% of the market. 

This, coupled with nearly $6 trillion of fiscal stimulus, has created a lot of excess capital. The supply chain disruptions are amplifying this situation as there is less product to meet demand.

The Fed wants to tighten these financial conditions. It laid out an aggressive rate hike path that puts the Fed Rate near 2.50% by the end of the year. Now it is looking to use its second tool- balance sheet reduction. It provided some insight into its plans in the latest minutes.  

The Minutes

The minutes are from the Fed’s March meeting. Members unanimously decided that conditions warranted commencement of the balance sheet runoff at a coming meeting. As Brainard stated, the pace needs to be faster than the 2017-19 reduction which was approximately $50 billion ($30 billion in Treasuries, $20 billion in Mortgage-backed Securities).

The Fed can implement ‘caps’ that limit how much it would let run off. If we use the prior runoff as an example, the Fed Treasury cap was $30 billion. This means that if it sold $40 billion in Treasuries, it would reinvest $10 billion. This allows the Fed to control flow and provide a lever to adjust how aggressive the pace of deleveraging. 

The minutes showed participants generally agreed that monthly caps of $60 billion in Treasuries and $35 billion would likely be appropriate. This means the Fed would allow approximately $95 billion to runoff its sheet monthly, nearly twice the pace of the 2017-19 reduction.

Visual Sample of 2017-19 Treasury Reduction: 

This is slightly higher than the market anticipated but not a complete surprise as there were warnings about the more aggressive pace.

These figures are not set in stone. the Fed is mapping out what it wants to do. The FOMC expects to make a formal announcement in its May 3-4 meeting. The language in the minutes- ‘participants generally agreed’, ‘would likely be appropriate’ -provide flexibility.

The committee stated that caps could be phased in “over a period of three months or modestly longer if market conditions warrant”. 

There was some divide on the March meeting rate hike. Most wanted to move 50 basis points but the uncertainty around the Ukraine war gave some pause and led to the 25-basis point decision. Many participants see one or more 50 basis point hikes as appropriate. The CME Fed Fund Futures predicts an 81% chance that there will be a 50-bais point hike and priced into market assumptions. 

There were no surprises around the rate commentary. The formulation of the balance sheet was what the market learned. 

How will the markets react?

The market has proven to be resilient. Of course, it knew the Fed had its back. This is no longer the case. Investors should be a little more cautious.

There are a lot of dynamics in the market: Fed Policy, Inflation, Supply Chains, and Geopolitical Unrest. Mid-term elections are on the horizon providing further uncertainty. The idea that the Fed is going from arguably the most dovish Fed to the most hawkish Fed, certainly since Volker, suggests the potential for a financial hiccup.

To be clear, this is not the Great Financial Crisis. Fed Chair Jerome Powell stated in his press conference that the reason the Fed felt it could be this aggressive is because of the strength of the U.S. economy. Consumers remain flush with cash and employment is strong. Economic data has not shown any signs of cracking with last week’s strong jobs number being the latest sign.

One key item to remember, this week’s price action comes amid a scarcity of news. The Fed Minutes was the biggest event of a very quiet week. This leads to an outsized impact on sentiment. 

That changes next week as earnings move into focus. Expectations will be low, providing the potential for better-than-feared results to boost sentiment. 

In addition, the news from the Fed today remains a path with exit ramps. Recall at his press conference, Powell said the central bank has a better sense of how rate increases affect financial conditions while the balance sheet runoff is still relatively new. It is less certain about the end results.  As he said, “we want to avoid adding uncertainty to what’s a highly uncertain situation already”.

The bottom line is that investors need to proceed with some caution. The liquidity levels in the pool are declining. This will lead to volatility around asset price discovery. That is not to say sell everything and head for the hills. The economic backdrop is too good. Banking a few profits and adding some cash to buy oversold names you have wanted to own is a prudent way to approach this environment. Add slowly and stay patient. Opportunities will arise, they always do.