Tuesday, September 19, 2017

FOMC Report September 19-20; If Unsure, Announce Balance Sheet Reduction

After three consecutive quarterly policy rate hikes, the Fed is likely to allow the fed funds policy path a pace change as it awaits more definitive indication that inflation is proceeding toward its two percent target.  If volatility is to be a guide, there appears some room for path variance from the strict quarterly removal of policy accommodation.  Actual and implied volatility measures remain at historically low levels as the September FOMC meeting approaches.

Low levels of volatility are generally welcomed as they speak of some level of confidence afforded current and the immediate future state of affairs.  Clarity of Fed intentions is a strong driving force for market implied volatility and the term premium on bonds. 

For over 12 years I have discussed how economic agents will adjust their levels of risk taking on the basis of the ‘visibility’ of the Fed’s policy path.  Visibility is like Fed transparency on steroids as it leads to a much clearer vision of future policy rates, whereas transparency is simply an open book.  In 2005, when I first started writing about this less understood condition, my intention was to express concern that the ‘restrictive’ policy path the Fed was trying to execute was a historical blunder.  The visibility provided by a telegraphed “measured pace” policy initiative encouraged rather than discouraged risk taking.  At that time, economic growth was well above potential and a more serious effort was needed to check animal spirits.   

Since the onslaught of the financial crisis, many have acquired a greater respect for the nature of Fed guidance.  Seen even as a policy tool now, Fed guidance is used when policy rates are too near the zero bound for lowering and as a substitute, assurances are made as to the duration the Fed will hold the policy rate at a low level.

It is the path understanding more than it is the particular rate which gives the benefit to animal spirits.  As the Fed moves away from regular policy rate hikes, as is now likely the case without a rate hike at this September FOMC meeting, there is a risk that insufficient policy awareness may prove detrimental to a willingness otherwise to engage in productive enterprise.  Right now, the Fed seems to be given a pass on September.   

Market pricing of Fed Funds and Eurodollar futures suggests roughly a 50% chance for a December rate response.  However, unless the Fed does raise the policy rate in December, there may be a strong reaction to the break from the earlier, three ‘dot’ declared, ‘predetermined’ policy path.  The Fed returning to a more ‘data dependent’ guideline for policy rate determination rather than the current more scripted path, could cause an upheaval in the form of higher volatility as economic agents become less convinced they understand the likely path for policy rates.

Consider the charts below that demonstrate the tendency for measures of volatility to respond to a certainty surrounding the visibility of the fed funds policy rate path.  The Merrill Lynch Bond Volatility Index (‘MOVE’) and VIX moved lower as economic agents came to understand the Fed’s policy path back in 2005.  Those volatility measures then began to increase when the Fed’s policy path became less known.  


Notice how the indexes fell hard as the Fed moved into its ‘measured pace’ directive and how that ended when the Fed could no longer proved wanted visibility at the onset of the financial crisis.  See also the recent fall in the indexes as the Fed began to show consistency in policy rate path.  


I have used a 30 day moving average to smooth the index data.  I have also included a graph of the ‘term premium’ to help demonstrate that here too, the tendency is for lower term premium in known Fed policy periods and higher term premium accompanies less certain policy rate times. 

Finally, the Fed is widely expected to provide a starting date for the reduction in its balance sheet of Treasury and mortgage securities.  Because this program has been well advertised with exacting details and because initially only a very small bite will be taken out of the portfolio, the announcement of a starting date is not expected to create any meaningful Treasury price movement.  With the recent hurricane activity causing noise to economic statistics, the Fed may be additionally interested in beginning a balance sheet reduction in the near term, lest they are data hampered from adjusting policy rates through year end. 

While, the defined path of the balance sheet removal is a form of policy path guidance that all else equal does provide visibility and by that nature promote positive economic activity, the program does not have as strong an influence on the nature of animal spirits as does the understanding of the fed funds policy path.  As such, we are quite concerned that the absence of a rate hike by December will result in significantly higher realized volatility in the intermediate term which would increased the prospects for a curtailment in the capital investment and household spending.