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  • Why The Federal Reserve Might Spring A Surprise Wednesday; Bank Stocks Rally

Why The Federal Reserve Might Spring A Surprise Wednesday; Bank Stocks Rally

The Federal Reserve's hawks and doves agree on one thing: The time has come to begin scaling back the $4.5 trillion balance sheet bloated by market interventions in the wake of the financial crisis.

XWhile divisions appear deeper over how the Fed should adjust its key overnight lending rate, its usual monetary policy tool, policymakers could announce a change in reinvestment policy — letting its portfolio gradually run off as mortgage and Treasury bonds mature — at any time, including on Wednesday.

An announcement at the end of the Fed's two-day meeting this week wouldn't rank as a huge surprise. Although a Bloomberg survey of Fed watchers gave just 13% odds of a reinvestment change on July 26, most observers expect it to happen at the next meeting on Sept. 19-20. Still, an earlier launch could have a few repercussions, albeit ones that are likely modest in scope.


Shifting reinvestment policy this month would send a few not especially welcome signals to investors. One signal would be that Fed committee members are getting a bit nervous about equity and other asset values. Another would be that the hawks aren't convinced by the recent muted inflation data and want to maintain flexibility to hike rates earlier than December, when market pricing suggests the next hike will come.

On the margins, a reinvestment shift on Wednesday would likely be positive for bank stocks like Bank of America (BAC), Morgan Stanley (MS), Citigroup (C) and Dow component JPMorgan Chase (JPM), which have mostly been sidelined in the latest phase of the stock market rally that was abetted by dovish signals from the Fed.

On Tuesday, as the Fed began meeting and The Conference Board's Consumer Confidence Index registered its highest level for present conditions since 2001, the 10-year Treasury yield jumped 6 basis points to 2.31%. Meanwhile, Citigroup gave upbeat earnings projections at an analyst meeting. Citigroup rose 3.1% to 68.16 in afternoon trade on the stock market today, near its recent 7 1/2-year high.

Morgan Stanley popped 1.9% to close at 47.61 and remains within a buy zone after breaking out of a cup-with-handle base on July 19, clearing a 46.76 entry. Bank of America climbed 2.4% to 24.48 and is closing in on a buy zone above 25.11. JPMorgan rallied 1.7% to 92.80 and remains within a buy zone above 89.23.

Meanwhile, superregional bank PNC Financial Services (PNC) advanced 1.7% to 129.33. PNC broke above a cup-with-handle buy point at 128.35.

IBD'S TAKE: Visit IBD Stock Checkup to see the top-rated companies in the Banks-Money Center and Banks-Super Regional industry groups based on earnings, revenue, margins and stock performance.

Economists see a gradual move away from the Fed's current stance of reinvesting all principal from maturing bonds as likely to put upward pressure on long-term interest rates. Goldman Sachs figures the shift could raise the 10-year Treasury yield by 20 basis points over time. That would contribute to an upward sloping yield curve, a positive for banks' net interest margins.

Another potential impact of a Fed reinvestment policy shift on Wednesday might be a halt to, and partial reversal of, the dollar's recent dive to its lowest level in more than a year. The falling dollar, at least partially a response to expectations of a more patient Fed, is a boon to the earnings of U.S. multinationals such as Dow components Apple (AAPL), Boeing (BA) and Microsoft (MSFT) and has helped support the current rally.

Fed chief Janet Yellen's July 12 testimony to Congress, along with a speech by leading Fed dove Lael Brainard the prior day, helped spark the current stock rally. Yellen made clear that the softening in inflation since March had "made it difficult to form a consensus view" on near-term interest-rate policy, wrote Ward McCarthy, Jefferies chief financial economist.

For now, Yellen will be content to watch the data for clearer evidence that inflation is on the rise because the Fed can begin scaling back its balance sheet in the interim. While the initial reductions will be quite modest, up to $10 billion per month, the Fed members have signaled that they want to have a window to implement the change while holding rates steady to avoid any market turbulence.

Brainard offered an even more dovish outlook for policy than Yellen, insisting that rate hikes must pause, but allowing that a reinvestment shift was warranted. Yellen is sure to take the deal, the only question is whether it will become official on Wednesday or in two months.

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