The Week Ahead – Shedding a Few Pounds... The Healthy Way

Welcome to “The Week Ahead” where each Friday we take a moment to provide our thoughts on what we can expect in markets and the economy for the upcoming week.

It starts off innocently enough. A few gummy bears here and there. One, two, or three mini-Snickers bars (I mean, they’re mini right?). An extra slice of pizza. Partaking in the office birthday cake. Sometimes it’s a conscious decision, drinking protein shakes to help bulk up. The years go by and one day you’re on the scale wondering, what happened and how do I lose this weight and return to “normal”? That’s the Fed. 

The Fed meets next week and given that we just saw a Fed Funds rate hike at the last meeting in June, the third and final hike they’ve earmarked for 2017 most likely will not occur until December given the recent weak inflation prints. What market participants are really looking for are more details on the Fed’s diet plan for balance sheet normalization.

Now to properly lose weight, a balance between exercise and diet is needed. It’s tough to get back on that gym horse and sometimes baby steps are needed. The Fed instituted a zero-interest rate policy in December 2008 and didn’t hike rates for seven years, with lift-off from zero occurring December 2015. It waited an entire year for hike number two. Rate hikes three and four happened in March and June of this year. The Fed has gone from not being in the gym, to walking on the elliptical machine, to the stair master now.  

Now about that diet. Prior to the Great Financial Crisis, the Fed’s balance sheet fluctuated between $700 billion and $800 billion. The first Quantitative Easing program (QE 1) lasted from December 2008 through June 2010 and we saw the Fed’s balance sheet jump to $2.1 trillion. QE 2, November 2010 through June 2011, saw an small increase to $2.7 trillion. QE 3, September 2012 through October 2014, saw the Fed’s balance sheet balloon up to today’s current balance of $4.5 trillion.  $40-$75 billion a month can do that to a balance sheet. A recent survey of primary dealers, or banks that do business directly with the Fed, had a median view that the Fed will eventually shrink their balance sheet to $2.75 trillion and not back to the $700-$800 billion pre-recession balance. 

While details have been scant so far and a formal announcement may not even occur until September, the language from the last few FOMC meeting minutes have made it clear that that the Fed is committed to begin normalizing in this year. Expect a similar process that we saw with rates: well telegraphed communication and a long runway before full takeoff (having learned their lesson from the taper tantrum in 2013). This will not be a completely smooth ride and as more details are released certain fixed income asset classes held by the Fed may see additionally volatility. We continue to remain tactically underweight to fixed income with underweights to U.S. treasuries and investment grade credit.

As noted above, it takes a combination of exercise and diet to lose weight, and in the case for the Fed, a combination of rate hikes and balance sheet normalization to shift from unconventional monetary policy back to conventional monetary policy.

Data deck for July 22-July 28: