The Fed has a new message. So far the market is not listening, but it should be, as the shift will have a profound effect on financial markets.
It started with the dissent at the last FOMC meeting from Neel Kashkari. In an unusual move, Kashkari published a blog piece explaining his dissent. Although he presented plenty of the usual reasons for not going along with the hike (mostly centered around the whole idea of the 2% inflation being a target, not a ceiling), Kashkari introduced the idea the Fed should be thinking about unwinding its balance sheet. Proving that stopped clocks are right twice a day, I have written about the possibility the Fed would shift their tightening bias through traditional Fed Funds raises, to balance sheet wind down - (The End of Calm Bond Markets). Continuing to raise rates while maintaining the large balance sheet could create a negative cash flow situation for the Federal Reserve. Given this worry, it makes no sense for them to tighten policy through rates when they can accomplish the same thing through the unwinding of their balance sheet.
It looks as if the Fed has taken this idea to heart. From Business Insider:
Today it was New York Fed President William Dudley’s job to hammer home the message. He’s one of the most influential members on the policy-setting Federal Open Market Committee. His New York Fed deals with the securities that are on the Fed’s balance sheet as a result of QE. And he said the Fed might start reversing QE this year.
With this call to shrink the Fed’s balance sheet, he is following in the footsteps of other Fed heads, including Cleveland Fed President Loretta Mester, San Francisco Fed President John Williams, and most notably Boston Fed President Eric Rosengren – a former “dove” who has been publicly fretting about bubbles in commercial real estate and housing and the risks they pose to “financial stability.”
So this theme unraveling QE, not in the foggy future but this year, is picking up momentum.
I disagree with Business Insider that the theme is picking up momentum. The Fed is bashing the message over our heads with a stick. That’s not momentum, that’s a pedal to the metal press.
The Federal Reserve is signaling that although they are not retracting the guidance for 3 hikes this year (meaning two more as we have already done one), any further tightening will be done from the unwinding of the Fed’s balance sheet. We had QE. Now we are going to have reverse QE. From Business Insider again - quoting NY Fed President Bill Dudley:
“It wouldn’t surprise me if sometime later this year or sometime in 2018, should the economy perform in line with our expectations, that we’ll start to gradually let securities mature rather than reinvesting them.”
“If we start to normalize the balance sheet, that’s a substitute for short-term rate hikes because it would also work in the direction of tightening financial conditions.”
“If and when we decide to begin to normalize the balance sheet we might actually decide at the same time to take a little pause in terms of raising short-term interest rates.”
BAM! There it is. The Fed will stop raising rates, and will instead start using the balance sheet to tighten policy.
I can’t say I disagree with anything good old Bill has said so far, but then he trotted out this gem:
And he is “not that worried that the markets are going to react to the changes in our balance sheet in a violent way because it’s already factored in.”
Bullshit. This policy is not factored in at all. Not even close. This whole Fed communication push is the first attempt to have the market understand the policy shift.
So what does it mean? And more importantly, how do we profit from it?
Let’s start with the obvious trade. If the Federal Reserve shifts from tightening monetary policy through Fed Funds rate hikes to balance sheet wind down, short rates will not rise as much as would otherwise be the case. At its extreme, the Federal Reserve would also be selling long dated securities. All of this adds up to a steeper yield curve.
Since Yellen has taken over as Fed Chairperson, the yield curve has been continually flattening as she has steadily withdrawn monetary accommodation.
Market participants are convinced the Fed will continue with this policy for some time to come. Speculators have never been more short 3 month Eurodollar futures contracts. These contracts are not foreign exchange contracts and have nothing to do with the European currency, but instead represent the best way to hedge US dollar short term rates.
So let me get this straight. Speculators are betting heavily on higher US short term rates, meanwhile, the Federal Reserve is signaling they might slow down rate hikes and replace it with balance sheet reduction?
There are many different ways to play this potentail unwind, but I certainly wouldn’t want to be short any US dollar fixed income instrument shorter than five years.
Yet yield curve shifts aren’t the only opportunities offered up from the Fed’s policy change.
The Federal Reserve owns $2.4 trillion of US Treasuries and $1.8 trillion in mortgage backed bonds. If I were a member of the FOMC board, I would push to wind down the mortgage back bonds first, but even if they choose a pro-rata wind down, the Fed will no longer be purchasing a large amount of mortgage backed securities that they were previously rolling.
Mortgage backed securities are different from US Treasuries. As rates decline, more homeowners refinance, so the mortgage instrument’s duration declines - right when you want the opposite to happen. When rates rise, fewer homeowners refinance, so the duration extends - again, right at the worse time. Mortgages are therefore negative volatility securities.
When the Fed was buying mortgages, they were removing volatility from the bond market. Conversely, when they sell, they would be demanding volatility. This is a good argument for owning fixed income volatility, but there is another aspect to the Fed’s change that might present an even better opportunity.
Ben Melkman from Light Sky Macro was recently interviewed on RealVision TV. There have been some really smart people on RealVision, but I think Ben might be at the top of my list. Instead of trying to rehash his point, here is his argument from that interview:
“The Fed has been a whole flow of mortgages for many years. And when the Fed buys mortgages, they don’t hedge any of the extension duration characteristics of mortgages… If the Fed stops buying mortgages, the private sector will have to start buying those mortgages, just as yields are going higher (ie: away from the average coupon). As you do that, those mortgages extend pretty quickly in duration. In that environment, those private sector holders have to hedge that duration extension risk by paying swap. So not only is the Fed making the private sector buy more duration as the mortgages extend that increases rapidly, and so I think two things happen. The curve sells off and steepens, and this becomes a good catalyst for what has been a very distorted swap spread curve (usually swaps trade at a lower yield than bonds, LIBOR risk should trade at a higher risk than government risk.)”
I have spoken about the strange anomalies in the swap market before - “How many other could never happens are out there?”. Heck, I even chronicled how, like an idiot, I was buying the swap spread “Only for the bravest and stupidest”
Back then I didn’t have a reason to bet on a return to normalcy except that negative swap spreads were dumb. But now I have a catalyst. The Fed’s shift in policy should cause the previously negative swap spreads to expand back to more normal levels.
Not only that, but there is another tailwind that Melkman did not mention. Theoretically swap spreads should never go negative. The counter party risk of the bank on the other side of the swap is higher than the risk free US treasuries. It makes no sense for swaps to trade lower than Treasuries. Yet they did.
Although no one knows with certainty the reasons, the lack of bank balance sheet availability was definitely a contributing factor. After the great credit crisis 2008, as regulations tightened, banks were less willing to extend credit for swap trades. Therefore demand for swaps outpaced supply, pushing the yield below Treasuries.
With Trump’s victory, it is safe to say that regulation is only headed one way. Banks are already opening up their balance sheets. And when combined with the recent rate rises, swaps have finally started to trade at levels more appropriate.
US 5 year swap spreads have even gone from negative to positive levels once again.
That means the US 5 year swap rate is above the 5 year treasury yield. Professor Malkiel can once again put that portion of the swap curve back into his lesson plan of efficient markets.
Farther out the curve, swap spreads are doing their best, but have not yet crossed out of “illogical” levels.
But, at the long end of the curve, the streams are still crossed.
Putting it all together, with the Fed signaling a move away from rate hikes as their preferred method of removing accommodation towards letting their balance sheet wind down, this should mean a steeper yield curve with widening swap spreads. Buying the 5/30 steepener, but instead of shorting 30 year Treasuries, replacing it with short 30 year swaps, means you can pick up an extra 40 basis points (for us hacks that don’t have ISDA’s, there is a swap future you can trade. See my previous post about swaps to learn how to hedge it properly.)
The Fed is communicating a big shift in policy. So far the market has not responded, but that just means there is more opportunity for those who understand how to profit from it.
Thanks for reading,