The Market Today
The Beginning of the End of a Nine Year Expirement
by Craig Dismuke, Dudley Carter
Today’s Calendar – Nine Years Later, the Fed Now Set to Begin “Normalization” of its Balance Sheet: It has been over seven years since the Fed has not been growing or maintaining the size of its balance sheet in an effort to stimulate economic activity. The initial quantitative easing program began in December 2008 with the first round of purchases ending in March 2010. For four months thereafter, the Fed allowed those maturing first purchases to roll-off and shrink its balance sheet. Quickly, they concluded that doing so was tightening monetary policy and decided in August 2010 to begin reinvesting all monthly cashflows. Now, seven years later, the Fed is prepared to begin letting its balance sheet shrink again, albeit at a prescribed, slow rate. While there has been a lot of uncertainty regarding the market impact of allowing the balance sheet to shrink, an initial take points to a limited market reaction. Even with the Fed telegraphing its plans beginning April 5th of this year, Treasury yields and financial conditions have not spiked higher. In fact, the 10-year Treasury yield has come down from 2.48% on April 5 to 2.23% this morning. Fifteen-year MBS yields (Bloomberg Current Coupon MBS quoted yield) have come down from 2.43% to 2.26%. Additionally, since the Fed laid out the details of its plans on June 14 in its Addendum to Policy Normalization Principles and Plans, Treasury and MBS yields have also dropped. Moreover, looking at broader measures of financial market conditions including TED spread, Libor/OIS spread, commercial paper spreads, long-term corporate borrowing spreads, municipal spreads, stock values, stock volatility, and expected bond market volatility; almost every measure shows easier financial conditions than on the dates when the Fed has tried to prepare the markets. If the market were going to have a material adverse reaction to the process, these measures would likely have moved in the opposite direction over these periods. As such, the FOMC is likely to commence with its balance sheet reduction plan at today’s meeting. As the Fed progresses with their plan, there is likely to be some flow impact to yields and risk spreads; however, it does not appear that the reaction will be abrupt nor large. It is also worth adding that, while calling this a “normalization” process could give the impression that they plan to reduce their balance sheet to its pre-QE level of $800-$900 billion in size, they are actually expecting to reduce it to somewhere between $2 and $3.5 trillion.
As for the rest of the Fed’s decision today, we will be most tuned in to the dot plot and how it may change. These changes could give us indications of what to expect with the Fed Funds rate going forward. For now, the Fed is projecting seven rate hikes between now and the end of 2019 while the markets continue to price in just two hikes. The FOMC decision will come at 1:00 p.m. CT with Chair Yellen’s press conference at 1:30 p.m.
Lost in the mix today is likely to be the August existing home sales report released at 9:00 a.m. CT. Sales are expected to increase fractionally after a 1.3% drop in July. Mortgage applications for the week ending September 15 gave back almost all of their previous week’s 9.9% bound, falling 9.7%. Applications continue to show choppy housing data but a continued, positive trend.
Overnight Activity – Stillness Overtakes Markets as Fed’s Decision Eyed: Global markets reflect little desire amongst investors to commit to new positions overnight as they await the Fed’s latest policy decision. Global equities have essentially held flat at Tuesday’s levels except for modest gains in China and a bout of weakness in Spain. U.S. stock futures are imperceptibly different ahead of the open with the biggest pre-market move reflected in the Dow’s 0.03% loss. Safer sovereign yields moved lower overnight ahead of the U.S. session. Yesterday started similarly, but U.S. yields ultimately reversed to extend the recent run higher (more below). Treasury yields are currently between 1.2 bps and 1.5 bps lower inside of 30 years (2-year – 1.39%, 5-year 1.82%, 10-year 2.23%). The Dollar has edged lower for a fourth session out of the last five and is back to just above its weakest level since January 2015. In commodities, U.S. crude is trading at what would be its highest close since July after bullish data on inventories. The API projected a crude build that was less than half of what the official data is forecasted to show today and also reported big drops in stocks of refined products such as gasoline. It was also reported that OPEC is discussing extending current production cuts past the current March cut-off. In the economic data, Japan’s trade data for August topped estimates (supportive of the global growth story) and retail sales in the U.K. were much stronger than expected.
Yesterday’s Trading Activity – Stocks Finish with Modest Gains for Another Record, Morning Reversal Extends Treasury Yields Climb: An early morning bid for Treasurys faded by the close and modest gains for stocks were enough to push the major indices to another round of record highs. Yields had fallen overnight but reversed during U.S. trading and the curve moved modestly higher from Monday’s levels. With just one day to go until markets expect the Fed to announce a start date for balance sheet normalization, the 2-year yield rose for a seventh consecutive session, adding 0.6 bps to 1.40%. The 5-year yield added 0.8 bps to 1.83%, the highest since July 27, and has now increased in each of the last eight sessions. The 10-year yield increased the most inside 30 years with a 1.6 bps increase taking the yield to 2.25%, the highest since August 15. Higher yields over the last week and a half have continued to push the financials sector towards the top of the S&P. Telecom companies, however, led the way after reports of merger talks between Sprint and T-Mobile boosted the sector. Despite slightly stronger stocks and a seemingly endless climb in yields, the Dollar softened to its weakest level in more than a month.