Investors have reacted to the Federal Reserve's plan to shrink the balance sheet so far in exactly the opposite way that policymakers had feared.
News about the U.S. central bank's strategy to start reducing its bond holdings, which began taking shape over the past week, has actually led to easier financial conditions via lower interest rates. That contrasts with the surge in Treasury yields that occurred during the so-called taper tantrum of 2013, when then-Fed Chairman Ben Bernanke hinted the central bank would reduce its purchases of Treasuries and mortgage-backed securities that were designed to bring down long-term interest rates.
This time around, New York Fed President William Dudley may have succeeded in convincing investors that the central bank would avoid any excessive financial tightening, according to Ben Emons, the Los-Angeles based chief economist and head of credit portfolio management at Intellectus Partners. Dudley told Bloomberg Television last week that policy makers might "take a little pause" in raising the federal funds rate when they start to shrink the balance sheet, as the reduction would "substitute for short-term rate hikes."
That remark "indicates that they don't want to have financial conditions tighten too quickly, if they hike and normalize the balance sheet" at the same time, according to Emons.
Minutes of the Federal Open Market Committee's March 14-15 meeting published on Wednesday didn't contradict Dudley, and signaled that participants wanted to gradually shrink the balance sheet to prevent a sharp rise in borrowing costs. That led investors to mark down the expected amount of Fed tightening in 2018, from roughly two rate hikes to about one and a half.
Answering questions Friday after a speech in New York, Dudley said "some people misconstrued" his comments a week earlier.
"A pause is pretty short already, and I think a little pause is even shorter than that," he said. The idea is "just to make sure that the balance-sheet decision doesn't turn out to be a bigger decision than you thought you were making," he added.
Moreover, the spread between yields on 10-year and 5-year U.S. Treasury notes widened as both yields fell, as investors bet short-term interest rates would be slower to rise than previously expected.
That may not be what Fed officials are looking for right now, as the median estimate of the 17-member FOMC is for three rate increases in both 2017 and 2018. Meanwhile the minutes revealed that the committee as a whole sees upside risks to their forecasts, a new development that may argue for raising rates more than currently forecast, not less.
The bigger message from investors may be a clue about the mechanism by which the Fed's bond-buying programs stimulated the economy in the first place. One prominent theory is that the most important effect of amassing the $4.5 trillion balance sheet through three rounds of purchases, known as "quantitative easing," was really the signal it sent about the central bank's intentions for short-term interest rates.
The idea was that, as long as the central bank was buying bonds, investors could rest assured that it would not be lifting rates anytime soon. One reason why the taper tantrum led to such a sharp increase in longer-term rates was that short-term rates shot up too, as investors pulled forward the likely timing of a central bank decision to hike.
Now that Fed officials' talk of balance-sheet shrinkage is being taken to imply lower short-term rates instead of higher ones, the argument that quantitative easing works primarily through the so-called signaling channel just got a little stronger.
