The Federal Reserve begins reducing its balance sheet – weekly update 25 September 2017

The US Federal Reserve’s balance sheet unwind

As expected, the Federal Reserve announced the beginning of its balance sheet unwind, in what is likely to be a key inflection point for post-global financial crisis monetary policy. In terms of mechanics, the process seeks to unwind the earlier Quantitative Easing programmes, reducing the balance sheet by essentially cancelling the proceeds from some of the maturing assets – as opposed to reinvesting the proceeds to maintain the size of the balance sheet, as has been done up until now.

We’ve highlighted before just how gradual such a programme is likely to be – the scheme starts next month by running off US$10 billion per month and will accelerate by US$10 billion every quarter until the balance sheet is being reduced by US$50 billion per month in a year’s time. To put that in context, the current balance sheet is around US$4.5 trillion (US$4,500 billion), meaning the direct impact is likely to be very limited – the main risk is to market sentiment at this point. Elsewhere the committee kept interest rates unchanged, and released their latest economic projections, which saw upgrades to GDP growth over the next three years and a marginal downgrade to inflation expectations for this year. In terms of the projected path for interest rates, there was no change to the members’ expectations for this year (one more hike) or next year (three further hikes), however longer-term expectations have cooled, with members now expecting the long run rate of 2.75%, compared to 3.00% previously. Despite the significance of the announcement, it was well signalled in advance, leading to a muted market response.

UK retail sales provided a boost

UK retail sales came in well ahead of expectations with 2.4% year on year (yoy) volume growth, up from 1.3% the month before, and against forecasts for a slip to 1.1%. The numbers excluding fuel were even better, with 2.8% yoy growth from 1.5% and forecasts for 1.4%. The details made for some interesting reading as well, with the main growth driver being primarily non-food elements, suggesting consumers are continuing to spend on discretionary items, despite rising costs.

Corroborating the price indices released last week, we saw strong rises in clothing and fuel prices – indeed, aggregate non-food store prices were up 3.2% on a year ago, and non-store prices were 3.3% higher, the highest rate of growth since 1992. Despite the upside surprise, retail sales have been slowing significantly this year from a run rate in the second half of last year of 5.6%, as higher prices and a credit splurge appear to have left the UK consumer somewhat tapped out.

Last week’s other events

• There were some notable sovereign credit rating changes last week. Portugal saw its sovereign debt upgraded back to investment grade by ratings agency S&P, as analysts there believe the country had done enough to address the debt problems that saw it junked in 2012. However, the UK saw its credit rating cut by Moody’s to AA2, now two steps below the ‘AAA’ gold standard – Moody’s highlighted Brexit-related challenges as the main concern.
• German elections have followed a recent theme across western democracies of rising populism and anti-immigration parties. Although Angela Merkel has secured her fourth term as Chancellor, her party suffered its worst result since 1949, with the CDU-CSU bloc securing just 33% of the vote. The far-right Alternative für Deutschland (AfD) fared much better than expected, entering the Bundestag with 12.6% of the vote. It is likely to take weeks if not months of negotiating to agree a coalition government to run the country.
• In Japan, the Bank of Japan made no change to its monetary policy, though there was some intrigue as one of the new members voted for further stimulus, suggesting the possibility of further policy divergence relative to other major Central banks. There are also rumours that President Abe was poised to call a snap election, taking advantage of an opposition in turmoil.
• US aggregate PMI numbers from Markit were mixed. Although Manufacturing PMI rose as expected from 52.8 to 53.0, Services PMI fell more than forecast from 56.0 to 55.1 (55.8 expected) causing the Composite PMI number to fall from 55.3 to 54.6, though it remained in expansionary territory.
• Eurozone PMI numbers were much improved. Manufacturing PMI rose from 57.4 to 58.2 (a fall to 57.2 was expected) whilst Services PMI rose from 54.7 to 55.6 (54.8 was expected), resulting in the Composite PMI figure increasing a whole point from 55.7 to 56.7.

The markets

There was relatively little movement in the major markets last week, with most of the main events largely priced in ahead of time. Equities were marginally up, with bonds easing off slightly, but overall a very quiet week.

Equities

Japanese equities led the pack, as the TOPIX index rose 1.6% for the week, followed by the MSCI United Kingdom, up 1.2% and then the rest of Europe up 0.9% (as measured by the MSCI Europe ex-UK). In the US, the S&P 500 was barely in positive territory, rising just 0.1% whilst the MSCI Emerging Markets index rose 0.3% in local currency terms.

Bonds

Ten year gilt yields rose five basis points (bps) on the week, closing the week at 1.36%, and US Treasuries were up the same amount, up five bps to 2.25%. The equivalent German bunds yields were just one bps higher to finish at 0.45%.

Commodities

Gold continued to weaken, falling below the US$1,300 mark as it finished the week at US$1,297.30/ounce. Copper was also slightly weaker, slipping to US$2.92/lb whilst oil was a little firmer, though still within a broad trading range, as Brent Crude finished the week at US$56.86/barrel.

Currencies

Currency markets were fairly quiet overall on the week, with the pound slightly weaker against the US dollar and euro, but marginally up against the Japanese yen. Sterling closed on Friday at US$1.35, €1.13 and ¥151.

1 month performance of major asset classes

The week ahead

There are some mid-level economic data releases out this week, but overall, the schedule is relatively light. Wednesday has US Durable Goods Orders reported for August, with forecasts for 1.0% month on month (mom) growth and comes after some volatile numbers, caused by the Paris Air Show. Friday gives us CPI readings from Japan (0.7% yoy expected from 0.4%) and the Eurozone (1.6% from 1.5% expected), as well as PCE Inflation in the US (1.5% from 1.4% expected), all of which will be closely watched as investors, economists and Central bankers try to unpick the inflation conundrum. The daily breakdown is as follows:

Monday – Japan releases the Nikkei Japan Manufacturing PMI reading early in the morning, with German IFO business survey results out later on. In the afternoon, the Chicago Fed releases its National Activity index, and the Dallas Fed updates its Manufacturing Activity index.

Tuesday – the main data of note are from the US, where Consumer Confidence figures are reported by the Conference Board, and it’s the turn of the Richmond Fed to report on Manufacturing Activity.

Wednesday – Japan reports Small Business Confidence and Machine Tool Orders in the morning, UK time, with UK Retail Sales from the CBI reported later. Durables goods orders from the US are out in the afternoon, as covered above.

Thursday – Eurozone business and consumer confidence is out in the morning, with US Initial Jobless Claims and the Kansas Fed’s Manufacturing Activity data released in the afternoon.

Friday – shortly after midnight, GfK reports UK Consumer Confidence, and the latest Lloyds Business Barometer reading comes out. This is followed by a raft of Japanese economic data, including Jobless Rate, Retail Sales and Industrial Production as well as the CPI reading mentioned above. In the afternoon, in addition to the inflation data from the Eurozone and the US, we also have US Personal Income and Spending data to see the week out.