The S&P500 fell sharply (-1.9%) after minutes of the Federal Reserve’s policy meetings showed discussions of the need to trim the Fed’s asset purchases at a faster pace.

Here are the excerpts from the Sales & Trading (Macquarie S&T) desk strategy piece published on 5 January 2022.

The FOMC Minutes provided important context on the potential for balance sheet runoff. This is likely to come earlier and be more aggressive than in the last cycle. There was notable hawkish commentary elsewhere in the Minutes including reduced optimism on labor force participation and greater concern with inflation. 

In Macquarie S&T’s year ahead outlook published one month ago, Macquarie S&T forecasted the first hike in June. The Minutes today suggest risks of liftoff occurring earlier than this with March and May both possibilities. 

Balance sheet run-off is likely to come sooner than in the last cycle 

The Minutes suggested that the “appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience”, reflecting a stronger economic outlook, higher inflation, and a larger balance sheet.

In the last cycle, the initial balance sheet run-off occurred after four hikes (in September 2017), when the policy rate had reached 1.125%. This was reached nearly two years after the first hike (in December 2015). 
If the same approach is taken as in the last cycle (waiting for 4 hikes before balance sheet run-off), this would imply run-off likely commencing sometime in 1H23 (likely within 12 months of liftoff). 

There is, however, reason to anticipate a potential even earlier run-off announcement. The Minutes suggested that “almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the federal funds rate”. This suggests openness to commencing after hikes 1, 2 or 3. 

Along these same lines, the shape of the yield curve could lead to an earlier run-off than otherwise. “Some participants” expressed that “relying more on balance sheet reduction and less on increases in the policy rate could limit yield curve flattening.” 

Once it starts, run-off may occur more rapidly than in the last cycle 

The bias of participants appeared to be towards a faster pace of run-off than what occurred in the previous cycle. This could include both a higher initial cap on monthly run-off and a faster pace of increase in that cap. In the last cycle, the initial cap was $10 billion per month (in 4Q17). This gradually increased over the next year, reaching $50 bln in 4Q18. 

Hawkish commentary elsewhere in the Minutes 

1) Labor supply: “A number of participants judged that a further improvement in labor force participation would take longer than previously expected.” 

2) Maximum employment already here or in sight: “Several participants viewed labor market conditions as already largely consistent with maximum employment…. many participants judged that, if the current pace of improvement continued, labor markets would fast approach maximum employment.” 

3) The pandemic and inflation. New variants were seen as posing “upside risks to inflation” with Omicron potentially exacerbating supply side frictions.

4) Inflation outlook. “Participants pointed to rising housing costs and rents, more widespread wage growth driven by labor shortages, and more prolonged global supply-side frictions.”