Markets Await Fed Moves to Trim Balance Sheet

With the Fed on track to announce a strategy for shrinking its big bondholdings, attention is shifting from how it will work to how it will affect financial markets: Will it be a snooze or a storm?

Fed officials are hoping for the former, seeking to avoid a replay of the 2013 "taper tantrum" that occurred when the prospect of declining central-bank bond purchases triggered global market convulsions, including big capital outflows and currency drops in emerging markets.

Many analysts expect a modest effect on markets, a view shared by Fed officials who believe their ample guidance about their plans should limit any negative reaction. Some caution, however, that they see potential for turbulence if investors are too complacent about preparing for the Fed's plans.

The Fed is likely to announce Wednesday, at the end of its two-day policy meeting, that it is raising its benchmark short-term interest rate by a quarter percentage point to bring it to a range between 1% and 1.25%, and signal that it expects about one more such increase this year.

Fed officials have said for months they were discussing how to reduce the balance sheet, and in May outlined a proposed approach that would let increasing amounts of securities mature over time. They could announce the adoption of the plan as soon as Wednesday.

The Fed's portfolio of assets grew to $4.5 trillion currently from around $800 billion before the crisis through a series of bond-buying programs aimed at lowering long-term interest rates. Allowing those assets to roll off could push up long-term rates.

The Kansas City Fed estimated in early May that shrinking the holdings by $675 billion by 2019 would have the effect of a one-quarter-percentage-point increase in the Fed's benchmark short-term interest rate. The Fed has raised the rate in three such increments since December 2015.

A mid-May Wall Street Journal survey of private economists found half of respondents reckoned the wind-down process would boost the yield on the 10-year Treasury note by just 0.2 percentage point or less over time.

A recent Fed board paper estimated that the expansion of Fed bondholdings since the crisis likely lowered the yield on the 10-year Treasury note by a percentage point from where it would otherwise have been. By 2023, the paper said, the yield would still be about a quarter percentage point lower, all else being equal, despite an anticipated shrinkage in the balance sheet.

Fed officials welcome the markets' muted response so far. It "suggests that there need not be a major reaction" when the process actually starts, Fed governor Jerome Powell said earlier this month.

The road could turn bumpier, however. Officials haven't revealed several key details that could influence the market effects, including when the process begins, its pace and the likely size of the balance sheet at the end.

Some analysts worry about the disconnect between current easy financial conditions and Fed efforts to tighten them. Stocks have climbed recently, yields have fallen and volatility is low, despite recent Fed rate increases and plans for more.

The gap could mean markets aren't ready for the Fed to start reducing its balance sheet.

"Markets are overlooking both the Fed's resolve to normalize policy and the impact their receding from bond markets will have," Shehriyar Antia, chief market strategist with the Macro Insight Group, wrote to clients. "The longer it takes for market expectations to converge with the Fed's policy trajectory, the greater the potential for an abrupt price move."

Some uncertainty about the effects of the wind-down stems from the operation's unprecedented scale. Before the crisis, the Fed bought and sold almost only Treasury securities to adjust short-term rates, and the relative size of those interventions was small.

Also, shrinking the balance sheet is only one way the Fed is trying to reduce the economic stimulus it is providing as the recovery gains strength. Fed officials see the slow growth and ebbing inflation of recent months as likely to be transitory, but some outside analysts and investors aren't convinced.

Some analysts note the process of unloading Treasurys and mortgage-backed securities markets could affect their relevant markets differently. While the Treasury market is vast and unlikely to be much affected by the Fed's action, the central bank's presence in the mortgage market is bigger.

Dallas Fed President Robert Kaplan, a former vice chairman at investment bank Goldman Sachs Group Inc., acknowledged the challenge in comments to reporters recently. "We would like to do this in a way that minimizes the impact on trading levels and the functioning of the Treasury market and mortgage-backed securities markets," he said. "I believe we can do that."

(END) Dow Jones Newswires

June 14, 2017 00:14 ET (04:14 GMT)