Will the Federal Reserve start to reduce its balance sheet or will it opt to wait a little longer?
Hold on to your hats: the time has arrived for the Federal Reserve to start unwinding its gigantic balance sheet. At least that is what the market is expecting from the Federal Open Market Committee (FOMC) when it convenes this week for a key policy meeting.
Minutes from recent meetings show a fissure opening up between those who favour waiting before reducing the $4.5 trillion balance sheet and those who think the US economy is ready for stimulus to be removed. As far back as June, Fed chair Janet Yellen said the central bank would start to reduce the size of its balance sheet “relatively soon”.
Markets expect soon to mean this week’s meeting. The next FOMC meeting is in October, but without a press conference to explain the Fed’s decisions, she may prefer to act now rather than waiting until December.
On hikes to the federal funds rate, whilst the market seems to doubt the Fed’s desire to act again, conditions do not appear to have altered significantly enough to warrant taking the foot off the tightening gas. Another hike by December should not be ruled out.
On the balance sheet, taking a simplistic view, if QE was good for stocks and drove down bond yields then unwinding it will be bad for equities, while Treasury yields should rise and the dollar with them. The market may be underestimating the potential for a dollar bounce on the expected reduction of the balance sheet. USD has suffered significant losses this year but appears well placed for recovery with core inflation expected to turn higher in to year-end.
With the European Central Bank ready to embark on tapering in October, the latest batch of purchasing managers’ indices will be parsed for clues about the pace of recovery in the Eurozone. Manufacturing and services flash PMIs are due on Friday.
Potentially a big week is in store for the New Zealand dollar. Current account figures and the latest GDP print are due out this week ahead of closely watched parliamentary elections. The kiwi has been particularly sensitive to news after a tight campaign that has so far failed to produce a clear favourite and left investors a little jittery. New Zealanders will head to the polls on Saturday.
Source: ETX Capital