More surprises from the Fed?

In my last post, I suggested that the odds favored a hawkish rate hike (see A dovish or hawkish rate hike?) and I turned out to be correct. However, some of the market reaction was puzzling, as much of the policy direction had already been well telegraphed.

As an example, the Fed released an addendum to the Policy Normalization Principles and Plans, which should not have been a surprise to the market:

The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.

• For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
• For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.
• The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve's securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

These steps were discussed in length in separate speeches made by Fed Governors Jerome Powell and Lael Brainard:

Under the subordinated balance sheet approach, once the change in reinvestment policy is triggered, the balance sheet would essentially be set on autopilot to shrink passively until it reaches a neutral level, expanding in line with the demand for currency thereafter. I favor an approach that would gradually and predictably increase the maximum amount of securities the market will be required to absorb each month, while avoiding spikes. Thus, in an abundance of caution, I prefer to cap monthly redemptions at a pace that gradually increases over a fixed period. In addition, I would be inclined to follow a similar approach in managing the reduction of the holdings of Treasury securities and mortgage-backed securities (MBS), calibrated according to their particular characteristics.

The only details that were missing were the exact numbers of the caps. Further, there are no discussions about active sales from the Fed's holdings, which was also not a surprise.

The Fed's gradual approach of allowing securities to mature and roll off the balance sheet means that investors who are watching the shape of the yield curve will not have to worry too much about Fed actions in the long end that might distort market signals. This chart, which I made from data via Global Macro Monitor, shows that the Fed holds an extraordinary amount of the outstanding Treasury issues once the maturity goes out 10-15 years.

These facts are all well known to the public and therefore the Fed's plans for normalizing the balance sheet should not be a big surprise.

The full post can be found at our new site here.