Honey, I reduced the balance sheet


The year 2022 promises to be disrupted not only for the markets but also for the central bankers.

With soaring inflation everywhere, the path to normalization should accelerate as no central bank can afford to be caught on the wrong foot when it comes to rate hikes.

In fact, three months ago, in an article published in this column (StarBizWeek: November 13, 2021), it was then pointed out that a policy misstep by central banks could eventually lead to a recession down the road.

In November of last year, it was pretty clear that the Federal Reserve (Fed) knew what it needed to do, but was still playing this waiting game because it needed further confirmation of the market recovery. of American Labor before taking any action. to raise rates.

At that time, the market was only anticipating two rate hikes this year, with one taking off in June 2022 and another in February 2023, making it three hikes in the space of nine months.

As of mid-November 2021, two-year, five-year, and 10-year U.S. Treasuries had market yields of 0.53%, 1.24%, and 1.58%, respectively.

Fast forward to February 10, 2022, and as the headline and January 2022 U.S. core inflation data hit 7.5% and 6.0%, respectively, all three U.S. Treasuries saw a sell-off and were last seen at 1.58%, 1.95% and 2.03%. , translating into a yield peak of 105 basis points (bps), 71bps and 45bps, respectively, in less than three months.

The US yield curve is starting to flatten as the short end rises at a much faster rate than the long end, while the yield gap between the 10 and the 2 has now narrowed to just 45 basis points against 105 basis points three months ago.

While the 10y minus 2y still has a positive yield spread, and is not reversing just yet, the market is already worried about doing it in time. After all, the spread, which reached 158 basis points in March 2021, has already narrowed by 113 basis points in less than a year.

Rising yields on US Treasuries have also led to higher yields in other markets and for the same reason: inflation. German dykes are above water, as are Japanese samurai bonds.

Bond yields are soaring around the globe that what was considered a safe haven has turned out to be hell for bond investors.

After all, the value of negative yielding bond papers globally, which at one point peaked at US$18.38 trillion (RM77 trillion) at the end of 2020, has now fallen to just 4 US$.14 trillion (RM17.3 trillion) – a loss in value equivalent to US$14.25 trillion (RM59.7 trillion) in just over a year.

2% by December?

Since the last two meetings of the Federal Open Market Committee (FOMC), the market has been unconvinced of the policy measures the Fed should take against the inflation impression that is at its highest level in four decades, either in the Consumer Price Index (CPI) or Personal Consumption Expenditure (PCE) or Core CPI and PCE.

At the December FOMC meeting, the Fed announced its intention to end its bond-buying program by increasing the pace of the reduction in its monthly bond-buying program to US$30 billion ( RM125.7 billion) per month, double the original plan of US$15. billion (RM62.8 billion) per month, allowing the Fed to end the tapering program by March 2022, three months ahead of previous forecasts.

At that time, the Fed had not yet forecast a hike, but the market then expected three rate hikes for this year, followed by three more hikes in 2023.

Five weeks later and at the last FOMC meeting in January, the FOMC presented a plan on how it intends to fight runaway inflation. While the Fed will begin raising rates in March, the pace of future increases will likely still depend on the data.

Jerome Powell, the Fed Chairman, also did not rule out the possibility of raising interest rates at every FOMC meeting thereafter.

With January’s inflation print, the market has now taken a more serious bet on the path and pace of rate hikes and the market now expects four to five more hikes after March’s rate hike.

Interestingly, for the March hike, traders have now placed a nearly 90% chance that the Fed will go for a 50 basis point hike next month, according to the FedWatch tool provided by the Chicago Mercantile Exchange.

Investors are even forecasting the likelihood that the Fed, having missed the mark and lagging the curve, will take action between meetings by raising that expected 50 basis points much sooner than the March FOMC meeting.

Overall, the market is now looking at a fed funds rate between 1.75% and 2.00% at the end of 2022, bringing the total rate hikes to between six and seven rate hikes for this year, including including the 50 basis points expected at the March FOMC meeting. .

Last week’s jobs report was a bomber for the market, further heightening investor anxiety.

Not only was January’s nonfarm payrolls of 467,000 a blowout number and well above the consensus estimate of 125,000, but the adjustments made for the previous two months also show how tight the labor market is. .

Moreover, with average hourly wages up 5.7% year-on-year, the Fed needs to act and act quickly to rein in the booming US economy.

Rate hikes are only part of the Fed’s story for 2022. In addition, the Fed is also expected to shrink its balance sheet following the 50 basis point rate hike in March, although the timing and quantum exact have not yet been communicated to the market.

Size Matters

With the size of the US Fed’s balance sheet at US$8.9 trillion (RM37.3 trillion) at the end of January 2022, the Fed has an additional responsibility in managing this gargantuan balance sheet.

Prior to the January meeting, the market did not expect the Fed to address the elephant in the room and expected at best that the Fed would play a passive role in allowing the bonds it holds to mature naturally and not to renew its commitment to issue new bonds. .

However, that narrative has now changed. Although a definitive plan has not yet been communicated, the market is concerned if the Fed takes proactive measures to reduce its balance sheet and the resulting impact not only on equities but on all asset classes. .

After all, it’s not just the Fed that has expanded its balance sheet since the pandemic began in early 2020, it’s all of the major central banks together.

The four major central banks, the Fed, European Central Bank, Bank of Japan and People’s Bank of China, had a combined balance sheet of US$31.2 trillion (RM130.7 trillion) at the end of January 2022, or about 11 US dollars. trillion RM (RM46.1 trillion) more than two years ago, and up to US$24 trillion (RM100.5 trillion) more since the global financial crisis of 2008/2009.

No wonder we’re seeing asset prices go wild globally, from equities to fixed income (well, at least before the recent selloff), from startups to bitcoin and the latest trendy, non-fungible tokens.

The height of this euphoria must surely be when we see that even companies in the United States with zero income can be listed with a market capitalization of over US$86 billion (RM360.3 billion) on the first day of quoting.

What do people smoke when they buy into these dream businesses that are driven by concept ideas and games as well as the theme of the season?

In conclusion, while we worry about the path and pace of rate hikes the Fed may take this year and possibly into 2023, it is central bank balance sheet shrinking that would be of most concern to bond prices. assets and valuations.

The moment the Fed begins to shrink its balance sheet, we could see investors running upside down and conceptual valuations coming to a screeching halt.

Pankaj C. Kumar is a longtime investment analyst. The opinions expressed here are those of the author.


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