The Federal Reserve isn't quite ready to start shrinking its $4.5 trillion balance sheet, minutes from the May 2-3 meeting released on Wednesday signal.
While policymakers continue to think it will likely be "appropriate to begin reducing the Federal Reserve's securities holdings this year," Wall Street banks including Goldman Sachs had begun looking for a shift as early as September. Now that seems unlikely to happen so quickly.
Perhaps even more important than the timing of the reinvestment shift is the "low" scale of the initial balance sheet reductions envisioned by the Fed.
As Pantheon Macroeconomics chief economist Ian Shepherdson explained, committee members endorsed "a staff paper proposing that the balance sheet roll-off should begin at a 'low' pace, increased gradually every three months, circumstances permitting." Shepherdson sees the Fed beginning to let maturing principal run-off from the portfolio as early as October, but at a level that won't fray investors' nerves.
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After the release, the Dow Jones industrial average, S&P 500 index and Nasdaq composite added to their modest gains on the stock market today, with the S&P 500 coming just short of a newall-time high. The 10-year Treasury yield slipped. JPMorgan Chase (JPM), Bank of America (BAC), and other banks stocks whose net interest margins can be sensitive to interest-rate changes remained fractionally mixed following the release. JPMorgan and BofA fell 0.1% while Citigroup (C) neared a buy point.
Reinvestment has kept the Fed's balance sheet steady in recent years. A decision not to reinvest maturing bonds would act as a monetary tightening.
JPMorgan economists highlighted a possibility that the Fed will pause hiking rates if core inflation readings continue to come in on the soft side, as they have the past two months.
But Fed policymakers signaled they see a rate hike "soon," backing up expectations for June hike.
After release of the March minutes, which policymakers first stated the a reinvestment policy shift would be appropriate this year, the Dow Jones industrial average and S&P 500 index turned negative. Bank of America and Dow component JPMorgan fell more than 1% that day, while fellow Dow component Goldman Sachs (GS) and Citigroup reversed lower as markets were caught off guard by the Fed discussion.
Prior Fed comments have made pretty clear that the central bank won't spring a sudden change on the market — Philadelphia Fed President Patrick Harker, a voting member of the FOMC policy committee, said he wants to make balance sheet reductions like "watching paint dry."
If policymakers wanted to telegraph that such a change might be forthcoming within the next few meetings, the minutes would be the place to do so.
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How markets will react to the change when it happens isn't exactly clear. Goldman Sachs sees the announcement of balance sheet adjustment as "a smaller tightening step" than the Fed's typical 25-basis-point rate hike, Goldman's chief U.S. economist, Jan Hatzius, explained recently.
Goldman has been expecting rate hikes in June and again in September, then a balance sheet tightening in December. But the recent run of weaker inflation readings suggests that the Fed might hold off hiking rates in September and instead announce a more market-friendly balance sheet adjustment, Hatzius said last week.
Before the Fed minutes' release, markets were pricing in an 83% chance of a June hike and 50-50 odds for the subsequent hike coming in January 2018, according to the CME Group FedWatch tool.
Interpreting the impact of a shift in the reinvestment policy isn't crystal clear. Fed Chair Janet Yellen explained in January that the 10-year Treasury yield could rise by 15 basis points over the course of 2017 as "the end-date for reinvestment draws closer." She noted that such a change in longer-term yields is roughly the same historical impact of two 25-basis-point hikes in the federal funds rate.
Bank investors weren't too concerned heading into Wednesday's Fed minutes release, with Morgan Stanley (MS) and most other banks stocks little changed after all rose more than 1% Tuesday. JPMorgan, Goldman and Morgan Stanley moved toward their 50-day moving averages, while BofA flirted with taking that key level. Citigroup, which fell below an aggressive buy point in the May 17 selloff, retook that entry last Friday and is near record highs.
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