By: Stephen McMannis, University of Pittsburgh
This past week the Federal Reserve became the central focus of financial markets not only across the United States, but the entire world. Traders found themselves trying to deal with a multitude of new information from the Fed, including continued balance sheet expansion, Federal Open Market Committee minutes, and a change in the Discount Window official lending rate.
With the Fed’s release of their weekly H.4.1 report they kept the trend alive by once again increasing assets on their balance sheet to a record high of $2.29 Trillion. At the same time MBS and Agency paper holdings continued to expand, though the Fed is nearing the end of its planned purchases. Within the next the month the trading desks at the Fed will, assuming no further liquidity injections, stop all purchases. Returning to the report, a more in depth look once again showed that bank excess reserves held at the Fed also continued to expand to another record high of $1.14 Trillion. This has been an interesting dynamic to follow considering any meaningful and expansive recovery should see reserve balances declining.
Wednesday’s FOMC minutes showed that the Fed was all too aware of this very issue and several members on the committee spoke about how to both shrink the balance sheet while at the same time reduce excess reserves. The management of these excess reserves is a critical component into managing the Fed Funds rate; though currently set at between 0- .25% is actually managed to around .15%. Banks are playing a waiting game with the Fed; not willing to expose lending capital by creating assets and loans until the Fed first raises rates. In fact the correlation between Fed Funds futures and reserve balances is very high; as the fed lowers rates, balances expand.
Across bond, equity, and currency markets investors have also been waiting for those very same interest rate increases and have even been pricing in eventual moves. Treasury yield curve steepening trades continue to be popular as fund’s buy Treasury-bills and sell Treasury Notes. So, what was the market’s reaction to the first effective rise in the Discount Window rate? The knee jerk reaction across markets was to buy dollars, sell equities, and sell treasuries. Notably, when the announcement was made Fed Chairman Ben Bernanke immediately reaffirmed the central bank’s stance on monetary policy. He stated ““These changes are intended as a further normalization of the Federal Reserve’s lending facilities,” and “The modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.” . With two sentences the central bank president stayed firm on the stance that rates will continue to remain low. However, Discount Window lending is relatively unimportant and is often a last resort, which is heavily scrutinized by institutions due to the negative stigma that comes with it. It serves as a very small piece of monetary policy and the central bank wanted to assure market participants that this increase did not translate into any reason to change in general rates.
On Friday, the knee jerk reaction across all assets was erased with equities posting further gains past Thursday’s highs. Eurodollar, 10 year Treasury Notes and Bond futures also reversed all previous losses on high volume, giving a bullish sign for next week possibly. However, as time goes on interest will inevitable rise- politicians and heads of state persistently worry about asset bubbles- and will not let loose monetary policy go unchecked. The question is: what does this mean for assets, especially without an intervening Fed?
Yields will rise across the curve; expect some initially flattening amidst a general rise to pre-crisis levels. Equities will have downside potential as investors pull money out of stock markets and look to grab fresh yields in bonds. Also working against equities will be a strong dollar; (dollar will gain in value as international funds flow in to seek higher yields) which to foreign investors makes US stocks more expensive in their native currency. A huge problem for the Treasury that will result is the massive cost of refinancing its debt in the years to come at these higher premiums. Over the past month, demand has come down for end of the curve (10, 20, and 30 year) maturities with weaker auctions and less participation by direct bidders- which generally is foreign central banks.
If you’re looking to trade this fundamentally a great option that has multiple aspects working in your favor is buying the USD/JPY currency pair. Before hitting a 15-year low the pair was an attractive sell thanks to a small percentage carry trade in which it was cheaper to borrow dollars and buy yen assets. Yet, as that has reversed so has the pair, and with the Bank of Japan’s expansion of liquidity programs and a persistent commitment to fight deflation the yen should continue to be weak. Buying any dips has become attractive, especially considering the strong historical positive correlation between US Treasury yields and the pair; the pair above 100.00 before year end is a legitimate possibility.
Going back to the Fed, this week has been full of what could be the very start of fundamental changes in monetary policy, and can be seen as a test of the waters. They showed their hand multiple times and were able track the impacts before actually making serious announcements. Over the next several quarters the Fed will once again be a key focus as they try to reduce the balance sheet, cut excess reserves, and try to control interest rates in an organized manner. Any change in Bernanke’s tone will be a major catalyst, and once it does, expect the Federal Reserve to take center stage again.
