The Path to Normalization: Long Awaited and Unprecedented Fed Balance Sheet Reduction Announced, But Investors Focus on Rate Hike Signal

Fed Chair Yellen has been very focused on telegraphing Fed moves well in advance, thereby avoiding “market shock” (see 2013 “taper tantrum”).  So today’s announcement of the “Great Unwind” (balance sheet reduction) was expected.  Still, there is some apprehension in the market for two reasons: (1) The Fed balance sheet expansion was unprecedented as will be the contraction and (2) The unwinding is another milestone signaling the end of the ultra-accommodative worldwide central bank intervention, or simply put: “you’re on your own, the training wheels are off”.  The pace of the contraction is very slow and measured: $10 billion per month through year end, then $20B in the first quarter 2018, $30 billion in Q2, $40 billion in Q3, then $50 billion per month ongoing.   At that pace, the “normal” Fed balance sheet of $1 trillion will not be reached until sometime in 2023.  That is assuming an uninterrupted pace which is very optimistic as the Fed may suspend the contraction if economic conditions deteriorate.  That is a much slower pace than the expansion rate of about $80 billion per month during most of QE.  Most likely a sell off at that pace would rattle markets.  The real news was more “telegraphing” as the Fed “dot plot” indicated a clear majority of committee members predicting a December 2017 rate hike.  The futures market jumped from less than 50% probability to 60%.  This showed a Fed willing to continue their pace of rate hikes regardless of recent reports indicating lower inflation than the stated 2.0% goal (however, last week’s CPI jump of 0.4% was a classic harbinger of inflation).  The dot plot also indicated a consensus for three hikes in 2018 and two in 2019, with a normalized overnight rate of 2.80% (up from 1.25% today. Stay tuned.  By David R. Pascale, Jr. , Senior Vice President at George Smith Partners