On Tuesday evening Federal Reserve governor Lael Brainard, a well-established dove, who of late has been rather more centralist than dovish, added her thoughts on the current situation the FOMC finds themselves in. On the funds rate she said that 'it will likely be appropriate soon' to adjust the Funds rate. She did add that if soft inflation data persists that it 'would be concerning and, ultimately, could lead me to reassess the appropriate path of policy.' So still data dependent but the concerns for the inflation outlook have helped US Treasury yields lower.
Of more interest was her thoughts on the balance sheet situation; as the market still has the 2013 Bernanke induced ‘Taper tantrum’ in mind. She said the timing for a change in balance sheet policy is coming 'into clearer view.' In her Q&A session, she noted that the mortgage backed and US Treasury markets have different market traits and that reinvestment levels should reflect those differences. She highlighted that she favours focusing policy on the Fed Funds rate as a single active tool of monetary policy, making the balance sheet 'subordinate' to the Fed Funds rate. She did flag that there 'may be circumstances when we may need to rely on balance sheet policy more actively', suggesting that an adverse shock could make it appropriate to commence reinvestment to 'preserve conventional policy space.'
Granted, the Fed hasn't been entirely clear as yet as to its strategy to reduce the balance sheet, but one the idea is to set a 'cap' on the amount of whatever class of holdings are allowed to mature without reinvestment. At the onset, the cap would be quite low and the Fed would gradually raise the cap, thereby allowing more securities to mature.
This scheme indeed would be slow-paced. San Francisco Fed President John Williams spoke on the subject Monday. Williams said that he sees a 'much smaller' balance sheet in years ahead and that the unwinding could begin with a 'baby step' later this year.
We think the ‘plan’ is to wind down reinvestment gradually, with adjustments in the cap probably being 'data dependent' as a means to retain flexibility. In a sense, it introduces a potentially lengthy phasing out of reinvestment as opposed to one in which the Fed would announce that it simply is letting all the short-dated bonds mature, which has much greater potential for disrupting carry trades. Under the 'cap' scheme, carry traders can persist, but bonds and notes would get increasingly more difficult to source. The considerable flexibility in this ingenious 'cap' scheme is the reason, we believe, all FOMC members suddenly seem to be on board with beginning the process of shrinking the balance sheet sometime later this year.
Tomorrow we have the all-important Non-Farm Payrolls for May with calls of a further 180k rise with average hourly earnings rising a little year-on-year to 2.6% from 2.5% and the unemployment rate stable at 4.4%. We feel it would take a very big shock to de-rail the Fed from a further 25bp hike at their next meeting, with their announcement on June 14th.