Primary Dealer Has a Big Call on Fed’s Balance Sheet

(Bloomberg Opinion) -- To TD Securities, the Federal Reserve’s sharp U-turn this week means bond traders should re-examine what they thought they knew about monetary policy under Chairman Jerome Powell, particularly when it comes to investors’ biggest obsession: the central bank’s balance sheet runoff.

In what appears to be one of the more aggressive calls on Wall Street, strategists at the bank now predict the Fed will end its balance-sheet reduction in June. They had previously thought it would last until October. That would leave the central bank’s holdings at about $3.8 trillion, down from as much as $4.5 trillion but still a ways away from the range of $1.5 trillion to $3 trillion that policy makers had estimated. This forecast is eye-catching, in part because TD Securities is one of the Fed’s 23 primary dealers.

Yet there’s an interesting twist in the report, appropriately titled “Speak Dovishly and Carry a Big Balance Sheet.” The strategists still expect Fed officials to increase interest rates once more this year, perhaps in September. To markets, which have become accustomed to Powell’s refrain that the fed funds rate is the central bank’s primary way of influencing monetary policy, this timeline might seem out of order. If the Fed halts its runoff in June — an accommodative move — why would it tighten financial conditions just three months later?

Gennadiy Goldberg, a senior U.S. rates strategist at TD Securities, explained it like this:

“We think the Fed will continue to use rate hikes as the monetary policy tool but will end runoff for technical reasons. They will likely suggest, like Powell noted last night, that balance sheet runoff will end before the Fed reaches the steep part of the demand curve for reserves in order to allow banks to continue to hold ample reserves.”

This makes a lot of sense. One reason that Powell likely referred to the balance sheet as being on “automatic pilot” in the past was because he was trying to convey that the runoff is not truly about monetary policy, no matter how many people try to equate a certain amount of reduction in assets to a given quarter-point increase in interest rates. Instead, it was seen as a way to “normalize” the plumbing of financial markets.

However, as I’ve noted before, the financial markets are not nuanced enough to understand this distinction. Throwing around the phrase “quantitative tightening” when the Fed is not actively selling anything is proof enough. After years of quantitative easing propping up asset prices, you can understand why investors expect a sell-off when the balance-sheet runoff is characterized as the exact opposite. 

Primary Dealer Has a Big Call on Fed’s Balance Sheet

This week’s Fed decision left no doubt that central bankers are beholden to financial markets. For that reason, I wonder if stopping the balance sheet runoff so soon, even if the market for bank reserves indicates it’s about time, would just create more confusion. It probably comes down to whether Powell sees the central bank’s next interest-rate move as a hike or a cut. Remember, here’s the key passage from the Fed’s separate statement on the balance sheet:

“The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments.”

In other words, its flexible. But only in one direction — to slow or end the pace of the runoff. NatWest Markets, another of the Fed’s preferred bond-trading partners, put it this way in a report on Thursday:

“The Fed would not cut rates before stopping balance sheet reduction, otherwise it would be confusing to markets why you are cutting the policy rate yet tightening via the balance sheet. So by moving up the potential date of the end of rundown, they move up the timing of a potential cut. To be clear, we are not calling for rate cuts. But there is a bit of forward guidance here where if the Fed needs to, they can accelerate the sequencing process.”

Of course, a range of scenarios could make any given timeline of Fed policy plausible. If policy makers are concerned about bank reserves, then ending the balance-sheet runoff sooner than expected is the right call. And they can emphasize that’s it’s not really a monetary policy decision (though TD Securities strategists acknowledge that “whether markets fully engage that view or not remains to be seen”). Afterward, if economic data start to look better and inflation picks up, then they should raise interest rates again when possible. “We intend to be at least as data dependent in our Fed policy forecast as the Fed itself claims to be,” the TD strategists wrote.

One thing is certain: Bond traders’ debate over the next tweak to the Fed’s double-barreled approach will rage on in the months ahead, which is probably exactly what Powell and other officials were hoping to avoid. Former Fed Chair Janet Yellen once equated the balance-sheet runoff to “watching paint dry.” Rarely has that ever been so riveting. 

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

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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