Halyard’s Weekly Wrap – 04/07/22

The minutes of the recently concluded FOMC meeting are rarely of interest since the Fed adopted the post-meeting press conference during Chairman Bernanke’s term.  Since then, Fed Chair’s have chosen to communicate the committee’s thinking at the post-meeting press conference.  Chairman Powell didn’t follow that pattern at the March 15 meeting as the minutes contained “bombshell” information.  Two days ago Fed Governor Brainard rocked the markets with her comments that the Fed was ready to begin to reduce its balance sheet.  That was confirmed yesterday when the minutes loosely detailed how balance sheet reduction was to be implemented.

First, and foremost, the minutes detailed that the monthly liquidation would be capped at $95 billion a month, $60 billion in Treasury’s and $35 billion in mortgage securities.  They qualified that amount by saying the amount would be informed by monitoring money market conditions, which drew a giant question mark from us.  One only needs to look at Treasury bill yields versus reverse repo (RRP) yields to discern that money market conditions are already out of wack!  Yield’s on nearby Treasury Bills are approximately half of the 30 basis points paid on the overnight RRP’s.  Moreover, outstanding Reverse Repo’s, at $1.7 trillion, dwarfs the $454 billion Treasury Bill float.

The plan is to allow coupon maturities to runoff and any shortfall will be made up by running off T-Bills, seemingly.  The plan is to be finalized at the upcoming FOMC meeting.  Similarly, that’s the plan for maturing MBS, but we see that as problematic, namely because of the recent rise in interest rates.  The average mortgage rate has risen to approximately 4.5% versus sub-3% last fall.  Based solely on that comparison, the demand to  refinance mortgage is virtually off the table.  That means that in order for the Fed to reduce their mortgage holding by $35 billion a month, they’ll need to sell mortgages at a loss.  They haven’t mentioned that as an issue but that is likely to be subject to scrutiny.

The operation is likely to commence following the May 4th FOMC meeting, at which we expect a 50 basis point rate hike followed by another 50 basis points at the June meeting.  That, at least, is how the Fed has laid it out.  Also, that’s assuming that investors don’t balk at the action.  Clearly, the bond market was not happy with the news.  The yield curve, as represented by the spread between the 2-year note and 30-year bond, which has been steadily flattening, steepened 27 basis points in the 24 hours after the announcement.  That’s an enormous reversal and likely to have caused substantial P&L pain to Wall Street.  While equity indices have sustained losses, the selloff has been muted.

The plan the Fed has laid out is quite clearly intended to communicate that they are serious about battling the inflation problem.  The question we have is will they have the will to follow through with their plan when the economy begins to falter and stocks suffer an meaningful drawdown.  We’ll likely know in the coming months.

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