Fed Begins Balance Sheet Unwind, Expects One More Rate Hike In 2017

Today’s the day.

On Nov 25, 2008 The Fed announced it would begin buying assets for its own account to save the world. In Oct 2014, The Fed ended its QE3 buying program but continued to reinvest the proceeds to maintain its $4.4 trillion balance sheet. Today, Janet Yellen announced the balance sheet will be allowed to normalize, with reinvestments slowed/stopped starting in October.

Headlines:

• *FED: HURRICANES UNLIKELY TO ALTER ECONOMY’S COURSE MEDIUM TERM
• *FED: JOB MKT STRENGTHENED, ECONOMIC ACTIVITY RISING MODERATELY
• *FED KEEPS RATES UNCHANGED, PLANS BALANCE-SHEET RUNOFF IN OCT.
• *FED FORECASTS STILL SIGNAL ANOTHER 2017 HIKE, 3 MORE IN 2018
• *FED REPEATS RISKS TO OUTLOOK APPEAR ROUGHLY BALANCED
• *FED SAYS FOMC VOTE WAS UNANIMOUS
• *FOUR FED OFFICIALS SEE NO MORE 2017 HIKES, UNCHANGED FROM JUNE ( Eleven Fed officials now see one more hike in 2017 versus just eight in June.
  – market odds only 50%)

The Fed cut long-term rates:

• *FED ESTIMATE OF LONGER-RUN FUNDS RATE 2.8% VS 3% IN JUNE

… or specifically, 2.75%, which assuming 2.0% inflation as the Fed does, implies a 0.75% real funds rate. So much for growth potential.

The rest of the forecasts were kept largely in line, with the Fed seeing slightly lower inflation in 2018 vs June and a modest drop in the unemployment rate in 2018 and 2019.

More forecast details:

Longer-run median unemployment rate 4.6% compares to previous forecast of 4.6% at June 14, 2017 meeting

• 2017 median jobless rate at 4.3% vs 4.3%
• 2018 median jobless rate at 4.1% vs 4.2%
• 2019 median jobless rate at 4.1% vs 4.2%
• 2020 median jobless rate at 4.2% vs n/a

Longer-run real GDP median projection of 1.8% compares to previous forecast of 1.8%

• 2017 median GDP growth 2.4% vs 2.2%
• 2018 median GDP growth 2.1% vs 2.1%
• 2019 median GDP growth 2.0% vs 1.9%
• 2020 median GDP growth 1.8% vs n/a

Longer run PCE inflation median at 2.0% compares to previous forecast of 2.0%

• 2017 median core PCE inflation 1.5% vs 1.7%
• 2018 median core PCE inflation 1.9% vs 2.0%
• 2019 median core PCE inflation 2.0% vs 2.0%
• 2020 median core PCE inflation 2.0% vs n/a

Longer run Fed funds median at 2.8% compares to previous forecast of 3.0%

• 2017 median Fed funds 1.4% vs 1.4%
• 2018 median Fed funds 2.1% vs 2.1%
• 2019 median Fed funds 2.7% vs 2.9%
• 2020 median Fed funds 2.9% vs n/a

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The big story, however, was the dots, where 12 Fed members now expect a rate hike in December vs 4 who believe rates wil stay unchanged. Also, one Fed member see two more rate hikes before the end of the year, or a 50 bps rate hike in December.

According to the “dots”, the median target for 2019 is 2.688% vs 2.938% in June; longer-run median is 2.75% vs 3% in June; 2020 median debuts at 2.875%. The median end-2017 dot is 1.375%, while in 2018 it rises to 2.125%, unchanged from previous. In June, only the 2019 median changed, declining to 2.938% from 3%

Forecast ranges narrow for 2018, 2019; longer-run widens:

• 2017 range 1.125%-1.625%, unchanged
• 2018 range 1.125%-2.725% vs 1.125%-3.125% in June
• 2019 range 1.125%-3.375% vs 1.125%-4.125% in June
• 2020 range 1.125%-3.875%
• Long-run range 2.25%-2.5% vs 2.5%-3.5% in June

A curious observation here is that the median 2020 dot (2.875%) is higher than the median Longer Run dot (2.75%)

A comparison of the dots vs the market:

Here are the maturing assets that will not be reinvested over the coming months…

Many market participants appears to believe that The Fed has given investors plenty of notice that they would begin to unwind their balance sheet and so the actual event will be like “watching paint dry.” This seems more than a little disingenuous given the great levels of confidence embued into the actual QE process to save the world.

As one wit on Twitter noted, “If I tell you everyday for 6 months that I am going to cut off your head on 9/20… you are prepared, but how will you react on 9/21?”

We shall see.

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Since the July FOMC Meeting, gold is the biggest gainer as the dollar loses ground…

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Notably the Taylor Rule (and the balance sheet-adjusted version) is implying The Fed should be about as tight as its been in decades…

And of course, here is what The Fed is really worrying about – they’ve lost control…

December Rate Hike Odds were at 53% heading into the statement…

Market liquidity flatlined heading into the FOMC statement…

This might help explains the three-card-monty game The Fed is playing, courtesy of ING, is the definitive “cheat sheat” matrix laying out all possible permutations of what can happen tomorrow, as well as the most likely market reaction.

Full Statement redline below: