Normalising US Financial Market Conditions: Fed Faces a Plethora of Challenges
Although the Federal Open Market Committee (FOMC) lowered its inflation forecast for 2018 last week, members retained their baseline forward guidance of three increases in the federal funds rate. Balance sheet adjustment will commence next month and will gradually increase in momentum over the next twelve months.
The bulk of the Fed’s holdings of mortgage backed securities (MBS) mature in over 10 years’ time, thereby placing the onus of lower reinvestment on the maturing US Treasury securities portfolio. Currently, the Fed holds 25% of the outstanding total for these securities, although there is considerable variation by individual issue.
The current size and composition of the Fed’s balance sheet is at variance with recent history, but they are similar to the mid-1940s. Shrinking the size and reducing the asset maturity of the balance sheet will lower the level of excess reserves in the commercial banking system.
Quantitative easing has distorted the dynamics underpinning the yield curve by suppressing the volatility and information embedded in short-term interest rates. Meanwhile, bond purchases by the Fed reduced the term premium demanded by investors, but the FOMC will need to manage short-term interest rate expectations as lower reinvestment commences in order to prevent any unnecessary backup in yields.
The current plan to normalise the balance sheet is not necessarily set in stone due to looming FOMC personnel changes and a potential easing of fiscal policy in 2018. A more aggressive monetary offset could be required if large tax cuts are passed into law.
The Fed owns MBS guaranteed by Fannie Mae and Freddie Mac, whose capital base will fall to zero under current financing arrangements on 1 January 2018. Failure to reform mortgage finance and clarify Treasury guarantees on Fannie and Freddie could usher in new mortgage products with higher pricing sensitivity to Fed policy, thereby placing the FOMC under greater political pressure to keep housing affordable.
DeSaque Macro Research Limited was formed by Said DeSaque in April 2012 with the intention of delivering independent global macro investment insights and new thematic long-term ideas to investors, along with an agnostic opinion of the markets.
Said DeSaque has over 29 years of experience working as a professional economist in financial services, primarily based in London. His working role has involved extensive travel around the world, bringing him into contact with investors of different cultural backgrounds and investment requirements. Prior to establishing DeSaque Macro Research, Said held positions as Senior Economist and Investment Strategist at US banks Robert W Baird and William Blair. He began his career as a graduate at PaineWebber in 1986, where he became Head of the London Economics Department in 1996. This role allowed him to engage with senior investment professionals, alongside regulators and provided a unique perspective of market intelligence at work.
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