Summary:

• The Fed is expected to start shrinking its balance sheet on Wednesday
• Expectations regarding future rate moves will affect US dollar
• EURUSD, US500 among markets to watch

In a month of central bank meetings we are yet to hear from the US Federal Reserve. The Fed has been known for announcing policy changes at the final meetings of a given quarter – they increased rates in December last year and then in March and June this year. A repeat is nearly out of question this time around but an equally important decision needs to be taken: how to reduce a giant balance sheet. Let’s take a quick tour on market expectations and instruments that could be affected.

How did the Fed accumulate a $4.5 trillion balance sheet and why would it reduce it?

A simple world of adjusting just interest rates ended in 2009 when central banks realized that slashing policy rates to 0% was not enough to revive the economy. The Fed was among the first banks to decide on “quantitative easing” (QE), a program where it bought debt securities to its balance sheet and at the same time injected cash to the economy. Throughout three stages of that program the Fed’s balance sheet ballooned to $4.5 trillion, nearly 5 times the pre-crisis size. Now that the economy is doing better the central bank wants to start reducing it back to a “new normal” if only because it wants to have room to use the QE program again when some kind of a crisis arrives.

The Fed accumulated a massive balance sheet when it tried to revive the economy. Now it’s time to unwind it. Source: Heritage.org 

How could balance sheet reduction work?

Do not expect the Fed to throw a vast amount of bonds at the market. That could cause a domino sell off across many markets and end a period of low volatility. Janet Yellen is well aware of those risks and will tread cautiously. The Fed holds different bonds that pay interests and mature over time and what the bank will simply stop reinvesting some of these proceeds. It is expected that the Fed will aim at $10billion balance sheet reduction per month. This is certainly a cornerstone decision but keep in mind that the ECB alone keeps buying bonds at the pace of 60 billion euro per month and the Bank of Japan has an active QE program as well.  

What else to look for?

Markets seem to be well prepared for a moderate balance sheet reduction but investors do not know what the future holds in terms of interest rates. The FOMC dot plot (look at the chart below) communicated one more hike this year, 3 more in 2018 and another 3 in 2019. Markets will look for a downward revisions here but even after revisions expectations of FOMC members (yellow dots) are bound to remain well above market pricing (white line). Low market expectations could be a chance for the US dollar but the focus will be on the nearest future – the market could as well end up disappointed if the majority of “dots” sees no more hikes this year.

Markets do not believe the Fed when it comes to future interest rates. Source: Bloomberg 

Markets to watch:

EURUSD

Low expectations regarding the Fed and increasing faith in the ECB led the EURUSD to 1.2050 from as low as 1.0350 early this year. The market has barely seen any correction and a culmination of psychological 1.20 and a low from 2012 (1.2050) could create a resistance zone. In case of market correction a strong support could be expected around 1.15 whereas a breakout could no immediate resistance on the weekly chart.

1.2050 is an important technical level for EURUSD. Source: xStation5 

US500

The US500 (S&P500 futures underlying) has just seen its fresh all-time highs as the market keeps moving well within the upward channel. A price action between 2013 and 2015 shows that simply remaining close to an upper limit is not a precondition for an imminent sell-off. Upper limit of the channel is currently some 100 points higher while a lower limit is around 2150 pts. that coincides with 2015 highs.  

Even after recording fresh all-time highs the US500 is not at an upper limit of the channel. Source: xStation5 

The Fed’s decision, statement and a dot-plot will be announced on Wednesday at 7pm BST and Janet Yellen conference will start 30 minutes later.