The Daily Prophet: Fed Finds a Way to Calm Nervous Bond Traders

(Bloomberg View) -- That sound you heard was a collective sigh of relief emanating from the bond market. For months, traders have been wringing their hands over statements by the Federal Reserve that it wants to start shrinking the amount of bonds it holds on its $4.5 trillion balance sheet either later this year or in early 2018.  

Although the minutes from the Federal Open Market Committee’s May 2-3 meeting released today suggest that’s still the plan, the bond market rallied as preliminary details suggest central bankers are looking to do it in a manner almost no one expected. The concern was that the Fed would just let the entire $425 billion of bonds due to mature next year roll off and not reinvest any of the proceeds back into new bonds. The minutes show that the Fed is considering capping the amount that wouldn’t be reinvested. That approach allows for tweaking of the runoff, depending on market conditions, and enables the Fed to continue buying securities, according to the fixed-income strategists at Bloomberg Intelligence.

“This is a big shift in direction from what economists and street pundits had suggested,” Jim Vogel, a fixed-income strategist at FTN Financial, wrote in a research note titled “(Market) did NOT expect a balance sheet plan this smooth.” At the May meeting, almost all officials “expressed a favorable view” of a staff-presented general approach to shrinking the balance sheet that would involve gradually increasing run-off caps every three months, according to the minutes. The caps would eventually reach fully phased-in levels, which would then be held in place until the size of the balance sheet was normalized.

Dollar traders weren’t so happy. The Bloomberg Dollar Spot Index immediately dropped as some strategists said the minutes indicate that policy makers may be more cautious in their assessment of the economy than they had let on in public speeches. The line from the minutes that currency traders focused on was one that said “members generally judged it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory.” Any sense that the Fed is wavering on its plan to raise interest rates two more times this year would diminish the appeal of the dollar. It’s already the weakest-performing major currency this year amid concern that the economy won’t get any bump from the Trump administration’s pro-growth stimulus plans. “For now we still expect some recovery for the greenback, although we acknowledge that the risks are tilted toward a smaller U.S. dollar rebound than we currently forecast,” Wells Fargo currency strategists wrote in a note before the minutes were released.

Here’s an uncomfortable factoid that backs up the concerns of currency traders: The last time the Citi Economic Surprise Index, which measures the data that exceed forecasts relative to those that miss, has fallen this far, this fast, was early 2015. The economy then went into a marked slowdown starting in the third quarter that lasted 12 months and resulted in gross domestic product expanding at an average 1.275 percent rate. The latest miss came today, with the National Association of Realtors saying sales of existing homes fell 2.3 percent in April. That exceeded the 1.1 percent drop forecast by economists. With hopes fading for any of the Trump administration’s fiscal stimulus measures to be enacted this year, economists may rethink their forecasts for a second-half bump in growth. “A lot of the pro-growth, policy stimulus is now being priced out” of the markets, Michael Wilson, chief U.S. equity strategist at Morgan Stanley, said on Bloomberg Television.

The credit rating firms are starting to catch up with the bond market on China. The decision by Moody’s to cut China’s rating one level to A1 from Aa3 comes with that’s nation’s bond market lagging behind its global peers. The Bloomberg Barclays China Aggregate Index has fallen 0.73 percent this year, compared with a gain of 4.04 percent in the benchmark Bloomberg Barclays Global Aggregate Index. The downgrade may push Chinese companies to borrow even more from domestic banks as overseas debt becomes more expensive, increasing risks for the nation’s finance industry, according to Bloomberg News’s Bruce Einhorn and Dong Lyu. With growing indebtedness at home, compounded by a slowing economy, there’s a risk of a “negative feedback loop,” said Khoon Goh, head of Asia research for Australia & New Zealand Banking Group, who sees state-owned enterprises and property developers feeling the biggest impact. Since the start of the global financial crisis, Chinese companies have borrowed to keep the economy growing, pushing corporate debt to 156 percent of gross domestic product, from 100 percent in 2008, according to Bloomberg Intelligence. Most of that debt is held by state-owned enterprises, putting the government on the hook in case of defaults.

Fresh off the International Monetary Fund’s seal of approval for its economic reforms, Egypt made its way to the international bond market today to offer up $3 billion of debt. Six years after the uprising that ousted President Hosni Mubarak, officials are making headway to rebuild an economy where inflation tops 30 percent and key industries such as tourism and manufacturing have been hit by terrorism, high borrowing costs and lack of foreign investment, according to Bloomberg News’s Ahmed A. Namatalla and Lyubov Pronina. Today’s sale, though, came at an opportune time. Increased appetite for riskier assets has driven the cost of capital down for emerging-market issuers with the extra yield investors demand to hold their debt instead of U.S. Treasuries shrinking to about the narrowest in more than two years. IMF support comes after the country implemented a series of economic fixes such as hiking its benchmark deposit rate by 500 basis points the past six months in an effort to contain inflation. It also slashed the value of its currency in half to attract foreign capital while lowering fuel subsidies to shrink one of the Middle East’s highest budget deficits.

The big event Thursday for markets will be what OPEC and its allies decide in terms of production cuts. The heavy betting is that they will extend their agreement to reduce supply by another nine months after last year’s pact failed to clear a global supply glut or deliver a sustainable price recovery, according to Bloomberg News’s Javier Blas, Grant Smith and Golnar Motevalli. Six months after forming an unprecedented coalition of 24 nations and delivering output reductions that exceeded all expectations, some of the world’s largest oil producers faced the fact that they’d fallen well short of their goal. OPEC and 11 non-members agreed last year to cut output by as much as 1.8 million barrels a day. The historic agreement affected everything from the valuations of U.S. shale producers to the currency rates. “A nine-month extension is effectively a done deal, but because Russia and Saudi Arabia announced their support for it earlier in the month, the market may be disappointed,” said Amrita Sen, the chief oil market analyst at Energy Aspects, said in an interview. “If Thursday’s meeting ends with ‘just’ a nine-month extension, prices may sell off.”

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A Few Big Stocks Don't Tell the Whole Market Story: Ben Carlson

China Is Latest Proof That Investors Are Under Siege: Mark Grant

How the Saudis Blundered Into OPEC Cuts: Leonid Bershidsky

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Retirement Savers Really Do Need Government Help: Barry Ritholtz

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Robert Burgess is editor of Bloomberg Prophets.

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