March’s FOMC meeting minutes were set to hold all of the answers for markets over what balance sheet run-off would look like this time around from the Federal Reserve after Jerome Powell explicitly stated that the document would hold “a more detailed discussion” during the March press conference.
While the minutes did release new information, such as “participants generally agreed that monthly caps of about $60bn for Treasury securities and about $35bn for agency MBS would likely be appropriate”, the market impact from the release of the minutes was rather sanguine given that Vice Chair nominee Lael Brainard relayed much of the signal yesterday. When speaking at the Minneapolis Fed at a forum on inflation, Brainard stated that quantitative tightening would be far more aggressive this time around, with the process potentially commencing after May’s meeting. This was merely confirmed and partially quantified in the release of today’s minutes, resulting in a fairly dull event for US bond markets.
Upon the release of the minutes, 2-year yields rose by 4bps while the yield on the 10-year Treasury increased by only 3bps. The moves proved to be time limited however, with 2-year yields now 1.8bp lower on the day and 10-year yields 5.8bp higher.
This is dwarfed by yesterday’s 10bp increase in the 2-year and 15bps increase in the 10-year. In the FX space, the dollar rally resumed after a brief slip in the early afternoon of the European session. The resumption of the dollar strength was notable against low yielding currencies, but similar to the reaction in fixed income markets, the rally in the greenback has been moderate. For reference, USDJPY continues to trade below the 124 handle – a level that previously raised the prospect of intervention by the Bank of Japan – while EURUSD still trades above recent support levels at 1.0850. Losses in both respective currencies remain below a quarter of a percentage point on the day.
Within the minutes, much of the market focus rested on the Fed’s views on quantitative tightening (QT) given FOMC members have broadly aligned behind the view that a 50bp hike in May is warranted as things stand. On QT specifically, the committee was presented with a range of possible options, all of which featured a more rapid pace of balance sheet roll off relative to the 2017-2019 period. The options primarily differed on the size of the monthly caps for securities redemptions in the SOMA portfolio. Despite this, FOMC members broadly agreed on a pace of about $60bn for USTs and about $35bn for agency MBS, which is roughly in line with our prior beliefs that were based upon scaling the Fed’s previous roll-off cycle to the current size of their balance sheet and overall bond market liquidity. However, despite quantifying the likely upper bound for the pace of balance sheet roll-off at $95bn per month, market participants must be aware that this is unlikely to occur immediately.
The FOMC even outlined this in the minutes, stating “caps could be phased in over a period of three months or modestly longer if market conditions warrant”. While this suggests that the peak pace of balance sheet reduction is likely to be hit quicker than the 13-months it took during the past cycle, the removal of monetary accommodation is still likely to be gradually introduced such that $95bn isn’t withdrawn towards the end of Q2.
Further differences to the previous QT cycle appear in how the Fed aims to top-up its balance sheet reduction with active sales in months where the redemption of coupon securities sits below the monthly cap. This time around, owing to the Fed’s shift to an ample-reserves operating framework, the NY Fed will actively redeem Treasury bills where necessary to top-up to the monthly cap. This will be visible in September should the cap have been raised to $65bn per month by this point. The news of which temporarily helped to lift front-end Treasury yields, before they returned to trading lower on the day. On agency MBS, the Federal Reserve will look to actively sell their holdings beyond the aforementioned cap once balance sheet reduction is underway such that their outstanding balance sheet is predominantly skewed towards Treasury securities. This stance is unchanged from the previous cycle.
Monex’s March estimates of the Fed’s likely Treasury redemption cap proved only $5bn per month too hawkish
Simon Harvey, Head of FX Analysis