Key Points:
- Fed signals the likely start of a balance sheet taper next month
- Fed credibility gap suggests that many could be caught by surprise
- Watch for equities and bond markets to be under pressure
The past 24 hours have been relatively interesting for those of us who keep a close eye on the U.S. Federal Reserve. The FOMC minutes contained some interesting comments on the future of the central bank’s enormous balance sheet with most of the voting members supporting the commencement of a balance sheet taper at the next FOMC meeting. Subsequently, bond markets and U.S. equities (via S&P 500) could be in for a relatively rough ride ahead if the Fed sticks to its current game plan.
The biggest risk of an unwinding of the Fed’s balance sheet is the risk of a ‘taper tantrum’ occurring within markets. In fact, the Fed’s Rosengren has already commented that he believes that the vast majority of investors are ready and anticipating the Fed’s unwinding of their $4.5 trillion balance sheet. However, I beg to differ, given that the central bank’s credibility has continued to worsen over the past six months as they have systematically overestimated inflationary pressures within the economy.
Subsequently, it’s relatively hard to see how Bond and Equity market participants can be expected to take them seriously in the face of ongoing jawboning. It wasn’t too long ago that the Fed, and Yellen specifically, was perpetuating the 3 or 4 hikes for 2017 mantra. That specific rhetoric took its toll on the USD cross pairs and saw plenty of capital flooding into the greenback. So it is unsurprising that the air has now come out of the dollar in the aftermath of what can only be described as a sentiment of dovishness pervasively emanating from the Fed.
Therefore, the commencement of a balance sheet tapering phase is likely going to be met with some surprise on the market as people have become used to a central bank that is largely full of hot air. In an attempt to stave off significant market volatility, the Fed is likely to start the tapering process gently but the inevitable signal it will send to the markets is undeniable and this will in all probability kick off a relatively sharp round of selling.
Ultimately, bond and equity markets are likely to see plenty of volatility if the Fed’s balance sheet commencement process does indeed start in late September. Subsequently, watch for some sharp selling because there are still many within the market that believe the Fed is bluffing and when the process starts it will be relatively rough indeed.