How to solve a problem like the Fed s balance sheet

The minutes from the Fed’s March meeting, which are released this evening, could be more than just a formality, in fact they could give the market some much-needed direction depending on whether the Fed is willing to pull the trigger and start the long process of balance sheet normalisation.

It’s been an eventful week at the Federal Reserve after Richmond Fed President Lacker was forced to resign on Tuesday after he admitted leaking confidential information to an analyst back in 2012. Lacker was a noted hawkish member of the Federal Reserve, even though he wasn’t a voting member this year, and with him out of the way it is worth remembering that the make-up of the FOMC is now marginally more neutral.

It is worth keeping this in mind when it comes to the FOMC minutes that are released this evening. Some may argue that this makes the minutes redundant, after all, they don’t reflect the make-up of the Federal Reserve. We would argue that these minutes deserve a second look, especially if they bring up the issue of how to solve a problem like the Fed’s enormous balance sheet.

How to shrink a $4 trillion mountain…

The Fed’s normalisation of monetary policy will be two –pronged: firstly, raising interest rates from historic lows, and secondly, shrinking its $4.4 trillion balance sheet. Interest rates have already been raised, and the FOMC confirmed in its March meeting that it still plans on two further rate hikes this year. So, the missing piece of information that we could glean from these minutes is the balance sheet. Reducing the size of its balance sheet is no mean feat and if the Fed signals that it will shrink its balance sheet in the coming months then we could see the following reaction:

• A jump in Treasury yields, the 10-year yield could retrace recent losses and move back towards the March high above 2.6%, currently yields are 2.36%.
• Signs that the Fed is going to start reducing the size of its balance sheet could be the dollar’s best chance of staging a meaningful rally in Q2, if Treasury yields rise then this could drag up the buck.
• We would expect to see EUR/USD sink if the Fed does hint at the timing of when it will shrink its balance sheet. The euro could be particularly at risk because the ECB is still buying assets, in fact, before the end of Q2 the ECB balance sheet is expected to be larger than the Fed’s balance sheet.
• This could also weigh on stocks, if the Fed shrinks its balance sheet then there will be a reduction in the amount of money in the financial system, pushing up the cost of capital, which is bad news for equities.

Why the Fed may continue to err on the side of caution

In contrast to the above, the Fed’s Dudley pointed out in a speech last week that the Bank could taper the end of reinvestments in order to shrink its balance sheet extremely slowly. If it appears that this view is shared by the FOMC consensus then we could see the opposite reaction to the above, as this could be construed by the market as a ‘dovish’ way to shrink the balance sheet, which may weigh further on Treasury yields and the dollar.

So, ahead of the minutes investors should get ready to look out for three things: 1. any sign that the Fed is looking to start shrinking its balance sheet in the coming months. 2, will it be a dovish or a hawkish shrinking of the balance sheet. 3, the market reaction.