While the FOMC considers easing with rate cut(s), they continue to tighten the balance sheet by allowing MBS’ and Treasuries to roll off. This may be self-defeating argues Landon Whaley.
There has been a ton of digital (and literal) ink spilled and business media coverage devoted to speculation about the timing and magnitude of the Federal Reserve’s Open Markets Committee (FOMC) rate cuts. But as much coverage as there has been, no one seems to be discussing the balance sheet.
No matter what the Federal Reserve does (or doesn’t do) with rates, as long as they are shrinking the balance sheet, financial conditions will continue to tighten. If history has taught us anything, it’s that when a central bank continues to tighten during a growth slowing regime, it jump-starts a recession.
Remember, for every $200 billion in bonds, the Fed allows to “roll-off” its balance sheet is the same tightening consequences as if its actively raised rates by 0.25%.
In June, the Fed dumped mortgage back securities from its balance sheet at the fastest pace since the “QE-unwind” began. Total assets on the Fed’s balance sheet fell by $34 billion after shedding both mortgage-backed securities (MBS) and Treasuries. After June’s activity, the Fed now has $3.8 trillion in assets, the lowest amount since September 2013. In total, the Fed has allowed $648 billion in securities to roll off its balance sheet and this “normalization” is going to continue until September. The adverse economic effects of the roll-off are evidenced by the fact that U.S. data is deteriorating at an accelerating rate.
This balance sheet reality is further confirmed in the Fed’s own words: “…participants agreed that it was important to be flexible in managing the process of balance sheet normalization and that it would be appropriate to adjust the details of balance sheet normalization plans in light of economic and financial developments if necessary (emphasis mine) to achieve the Committee’s macroeconomic objectives.”
This balance sheet-related commentary is a long way from being dovish and tells us that while the Fed has stopped raising rates, it has no current plans to change its balance sheet policy.
You’re so Predictable
We have routinely discussed the predictable sequence of central bank events and resulting investor psychology: Central bankers turn dovish, investors rush to buy stocks because the juice is loose, stock markets rise, investors realize that central bankers turned dovish because economic conditions were guano, resulting in stock markets selling off quick, fast and in a hurry.
Similarly, there is a very predictable central banker progression:
- “The economy is overheating; we better hike now before it gets away from us!”
- “The markets don’t like our raising rates, but we are staying the course because we are data-dependent.”
- “The markets are really getting squirrelly, we’re staying the course, but now we’ve got one eye on what they’re doing.”
- “Markets are volatile, economic data isn’t as strong as it was three to six months ago, so let’s pause here and reassess.”
- Fast forward six months to a year, “let’s make just one rate cut…”
- Ten rate cuts later the Fed Funds rate is as low as it goes (+0.25%), effectively zero…and remains there for seven years.
- Repeat steps 1-6.
The Bottom Line
Nearly everyone believes a rate cut is coming next week, but there is a problem. Even if they cut rates, the balance sheet normalization will continue tightening financial conditions, at the margin. Beyond that, a rate cut at next week’s meeting is a wholly politicized move, and it will shine a light on the Fed’s lack of independence.
The Fed doesn’t have the data it needs to justify a rate cut at this juncture. Yes, growth has been slowing for the better part of a year, but growth isn’t a Fed mandate. They are supposed to drive monetary policy based on inflation and employment. Inflation has resumed its downward trend, but it hasn’t fallen far enough below the Fed’s 2% threshold to warrant action. The labor market remains one of the best we’ve seen in multiple decades, and although June’s employment numbers showed some chinks in the armor, it's not enough to drive a rate cut.
Despite the massive amount of speculation about when the Fed will cut and by how much (and why), there are far too many factors to know precisely what they’ll do, or when they’ll do it. Luckily for us, we don’t need to be a descendant of Nostradamus or Miss Cleo’s love child to trade the next six months profitably. Based on the current Fundamental Gravity, and the most likely progression of Fed policy, the only places to be on the long side are utilities, REITs, Treasuries, and gold.
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