Fed’s big balance-sheet unwind could be coming to an early end
NEW YORK: The Federal Reserve’s balance sheet may not have that much further to shrink.
An unexpected rise in overnight interest rates is pulling forward a key debate among US central bankers over how much liquidity they should keep in the financial system. The outcome will determine the ultimate size of the balance sheet, which they are slowly winding down, with key implications for US monetary policy.
One consequence was visible on Wednesday. The Fed raised the target range for its benchmark rate by a quarter point to 1.75% to 2%, but only increased the rate it pays banks on cash held with it overnight to 1.95%. The step was designed to keep the federal funds rate from rising above the target range. Previously, the Fed set the rate of interest on reserves at the top of the target range.
Shrinking the balance sheet effectively constitutes a form of policy tightening by putting upward pressure on long-term borrowing costs, just as expanding it via bond purchases during the financial crisis made financial conditions easier. Since beginning the shrinking process in October, the Fed has trimmed its bond portfolio by around US$150bil to US$4.3 trillion, while remaining vague on how small it could become.
This reticence is partly because the Fed doesn’t know how much cash banks will want to hold at the central bank, which they need to do in order to satisfy post-crisis regulatory requirements.
Officials have said that, as they drain cash from the system by shrinking the balance sheet, a rise in the federal funds rate within their target range would be an important sign that liquidity is becoming scarce.
Now that the benchmark rate is rising, there is some skepticism. The increase appears to be mainly driven by another factor: the US Treasury ramped up issuance of short-term US government bills, which drove up yields on those and other competing assets, including in the overnight market.
“We are looking carefully at that, and the truth is, we don’t know with any precision,” Fed chairman Jerome Powell told reporters on Wednesday when asked about the increase. “Really, no one does. You can’t run experiments with one effect and not the other.”
“We’re just going to have to be watching and learning. And, frankly, we don’t have to know today,” he added.
But many also see increasingly scarce cash balances as at least a partial explanation for the upward drift of the funds rate, and as a result, several analysts are pulling forward their estimates of when the balance sheet shrinkage will end.
Mark Cabana, a Bank of America rates strategist, said in a report published June 5 that Fed officials may stop draining liquidity from the system in late 2019 or early 2020, leaving US$1 trillion of cash on bank balance sheets. That compares with an average of around US$2.1 trillion held in reserves at the Fed so far this year.
Cabana, who from 2007 to 2015 worked in the New York Fed’s markets group responsible for managing the balance sheet, even sees a risk that the unwind ends this year.
One reason why people may have underestimated bank demand for cash to meet the new rules is that Fed supervisors have been quietly telling banks they need more of it, according to William Nelson, chief economist at The Clearing House Association, a banking industry group.
The requirement, known as the Liquidity Coverage Ratio, says banks must hold a certain percentage of their assets either in the form of cash deposited at the Fed or in US Treasury securities, to ensure they have enough liquidity to deal with deposit outflows.
The Fed flooded the banking system with reserves as a byproduct of its crisis-era bond-buying programs, known as quantitative easing, to stimulate the economy. The money it paid investors to buy their bonds was deposited in banks, which the banks in turn hold as cash in reserve accounts at the Fed.
In theory, the unwind of the bond portfolio, which involves the reverse swap of assets between the Fed and investors, shouldn’t affect the total amount of Treasuries and reserves available to meet the requirement. The Fed destroys reserves by unwinding the portfolio, but releases an equivalent amount of Treasuries to the market in the process.
But if Fed supervisors are telling banks to prioritise reserves, that logic no longer applies. Nelson asked Randal Quarles, the Fed’s vice-chairman for supervision, if this was the Fed’s new policy. Quarles, who was taking part in a May 4 conference at Stanford University, said he knew that message had been communicated and is “being rethought”.
If Fed officials do opt for a bigger balance sheet and decide to continue telling banks to prioritise cash over Treasuries, it may mean lower long-term interest rates, according to Seth Carpenter, the New York-based chief US economist at UBS Securities.
“If reserves are scarce right now, and if the Fed does stop unwinding its balance sheet, the market is going to react to that, a lot,” said Carpenter, a former Fed economist. “Everyone anticipates a certain amount of extra Treasury supply coming to the market, and this would tell people, ‘Nope, it’s going to be less than you thought’.” — Bloomberg
Malaysia and regional equity markets in the red
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In Malaysia, the selling streak has been ongoing for almost a month. As of June 8, the year to date outflow stands at RM3.02bil, which is still one of the lowest among its Asean peers. The FBM KLCI was down 1.79 points yesterday to 1,761. |
PETALING JAYA: It was a sea of red for equity markets across the region after the Federal Reserve raised interest rates by a quarter percentage point to a range of 1.75% to 2% on Wednesday, and funds continued to move their money back to the US. This is the second time the Fed has raised interest rates this year.
In general, markets weren’t down by much, probably because the rate hike had mostly been anticipated. Furthermore for Asia, the withdrawal of funds has been taking place over the last 11 weeks, hence, the pace of selling was slowing.
The Nikkei 225 was down 0.99% to 22,738, the Hang Seng Index was down 0.93% to 30,440, the Shanghai Composite Index was down 0.08% to 3,047.34 while the Singapore Straits Times Index was down 1.05% to 3,356.73.
In Malaysia, the selling streak has been ongoing for almost a month. As of June 8, the year to date outflow stands at RM3.02bil, which is still one of the lowest among its Asean peers. The FBM KLCI was down 1.79 points yesterday to 1,761.
Meanwhile, the Fed is nine months into its plan to shrink its balance sheet which consists some US$4.5 trillion of bonds. The Fed has begun unwinding its balance sheet slowly by selling off US$10bil in assets a month. Eventually, it plans to increase sales to US$50bil per month.
With the economy of the United States showing it was strong enough to grow with higher borrowing costs, the Federal Reserve raised interest rates on Wednesday and signalled that two additional increases would be made this year.
Fed chairman Jerome H. Powell in a news conference on Wednesday said the economy had strengthened significantly since the 2008 financial crisis and was approaching a “normal” level that could allow the Fed to soon step back and play less of a hands-on role in encouraging economic activity.
Rate hikes basically mean higher borrowing costs for cars, home mortgages and credit cards over the years to come.
Wednesday’s rate increase was the second this year and the seventh since the end of the Great Recession and brings the Fed’s benchmark rate to a range of 1.75% to 2%. The last time the rate reached 2% was in late 2008, when the economy was contracting.
“With a slightly more aggressive plan to tighten monetary policy this year than had previously been projected by the Fed, it will narrow our closely watched gap between the yield rates of two-year and 10-year Treasury notes, which has recently been one of a strong predictor of recessions,” said Anthony Dass, chief economist in AmBank.
Dass expects the policy rate to normalise at 2.75% to 3%.
“Thus, we should potentially see the yield curve invert in the first half of 2019,” he said.
So what does higher interest rates mean for emerging markets?
It means a flight of capital back to the US, and many Asian countries will be forced to increase interest rates to defend their respective currencies.
Certainly, capital has been exiting emerging market economies. Data from the Institute of International Finance for May showed that emerging markets experienced a combined US$12.3bil of outflows from bonds and stocks last month.
With that sort of global capital outflow, countries such as India, Indonesia, the Philippines and Turkey, have hiked their domestic rates recently.
Data from Lipper, a unit of Thomson Reuters, shows that for the week ending June 6, US-based money market funds saw inflows of nearly US$34.9bil.
It makes sense for investors to be drawn to the US, where the economy is increasingly solid, coupled with higher yields and lower perceived risks.
Hong Kong for example is fighting an intense battle to fend off currency traders. Since April, Hong Kong has spent at least US$9bil defending its peg to the US dollar. Judging by the fact that two more rate hikes are on the way this year, more ammunition is going to be needed.
Hong Kong has the world’s largest per capita foreign exchange reserves – US$434bil more in firepower.
By right, the Hong Kong dollar should be surging. Nonetheless, the currency is sliding because of a massive “carry trade.”
Investors are borrowing cheaply in Hong Kong to buy higher-yielding assets in the US, where 10-year Treasury yields are near 3%.
From a contrarian’s perspective, global funds are now massively under-weighted Asia.
With Asian markets currently trading at 12.3 times forward price earnings ratio, this is a reasonable valuation at this matured stage of the market.
By Tee Lin Say StarBiz
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