Will FOMC’s QE reversal affect T-note yields?
U.S. existing home sales expected to remain generally strong
Weekly EIA report expected to remain distorted by Harvey
Will FOMC’s QE reversal affect T-note yields? — The market is unanimously expecting the FOMC at its 2-day meeting that concludes today to announce a start date for its balance sheet reduction program. That start date could come as soon as Oct 1 since that would synchronize the program with calendar quarters. The FOMC has already announced that the program will cap security roll-offs at $10 billion per month to begin ($6 billion of Treasuries and $4 billion of mortgage-backed securities). The cap will then rise by $10 billion every three months until the maximum cap of $50 billion per month is reached.
The market is discounting a negligible 14% chance of a Fed rate hike today. However, the market has pushed the odds for a Fed rate hike by December up to 66% from 38% as recently as two weeks ago (according to the Jan 2018 federal funds futures contract) due to (1) the 3-week rise in inflation expectations, and (2) less-than-expected damage from Hurricane Irma in Florida. The 10-year breakeven inflation expectations rate has risen sharply by +13 bp to a 4-month high of 1.88% due to higher oil prices and the rise in the Aug CPI to +1.9% from June’s 11-month low of 1.6%.
The FOMC today is likely to keep its post-meeting statement language little changed, thus keeping its options wide open for a rate hike in December. The markets will be watching to see if the Fed dots today turn any less hawkish given the weak U.S. inflation performance. The Fed dots are forecasting a 3% funds rate by the end of 2019, which is far more hawkish than the market’s view of a 1.66% funds rate by the end of 2019.
The Fed has clearly telegraphed its balance sheet intentions and today’s expected start-date announcement is not likely to have any major immediate impact on the markets. However, the bigger question is whether the Fed’s balance sheet reduction program will have any progressive impact on T-note yields in coming weeks and months. The obvious interpretation of the Fed’s quantitative tightening is that it should push T-note yields higher since the Fed is reducing its role as a big buyer of Treasury securities, thus reducing demand for Treasury securities.
However, the Fed’s balance sheet reduction program will have an offsetting effect that could leave T-notes yields little changed on balance. Since the Fed’s balance sheet reduction program represents a tightening of monetary policy, the Fed will be under less pressure to raise interest rates, particularly early in the program when the Fed wants to gauge the effect of its balance sheet program before turning the screws on interest rates. Deferred expectations for Fed rate hikes should help T-note yields from rising much in response to the balance sheet reduction program.
Indeed, the 2013 taper tantrum episode is instructive on this issue. Former Fed Chair Ben Bernanke has said that he believes that T-note yields surged in 2013 after he mentioned that QE3 might be tapered later in the year, not because the Fed would be stepping back as a Treasury buyer, but mainly because a tapering would bring forward the date of the Fed’s next rate hike. Mr. Bernanke was essentially saying that he believes that the biggest impact on the T-note market is not from QE itself, but from its implications for the Fed’s interest rate policy.
According to this line of thinking, the Fed’s balance sheet reduction program will have a minor demand effect on the T-note market and most of its impact will instead come from perceptions of how it will change the Fed’s desire to raise interest rates. In that sense, the Fed’s balance sheet program may have little net effect on T-note yields.
U.S. existing home sales expected to remain generally strong — The market consensus is for today’s Aug existing home sales report to show a +0.4% increase to 5.46 million, recovering part of July’s -1.3% decline to 5.44 million. Today’s existing home sales report will be undercut to some extent by Hurricane Harvey, which made landfall on Aug 25. U.S. existing home sales remain in strong shape at only -4.6% below the 10-1/4 year high of 5.70 million units posted in March.
Home sales are seeing strength from strong consumer confidence, improved household balance sheets, and continued low mortgage rates. However, home sales are also seeing some downward pressure from near-record home sales prices and from mildly tight supplies. The median price of an existing home of $258,300 in July was just -1.9% below the record high of $263,300 posted in June. The 4.2 month supply of existing homes on the market is well below the long-term average of 7.0 months and mildly below the 2000-2005 pre-recession average of 4.5 months.
Weekly EIA report expected to remain distorted by Harvey — The market consensus is for today’s weekly EIA report to show a +3.4 million bln increase in U.S. crude oil inventories, a -2.5 million bbl decline in gasoline inventories, a -1.7 million bbl decline in distillate inventories, and a +5.0 point increase in the refinery utilization rate to 82.7%. Today’s EIA report for the week ended Sep 15 will continue to be distorted by Hurricane Harvey, which made landfall in Texas on Aug 25. Crude oil inventories have risen due to reduced refinery demand in the Gulf area, but have only shown a modest increase thus far and remain below last year’s levels at this time. Meanwhile, gasoline inventories have fallen sharply on refinery shut-downs on Harvey. The refinery utilization rate has plunged by a total of -18.9 points to 77.7% in the past two reporting weeks. Today’s expected +5.0 point increase would represent the recovery of less than one-third of the refinery capacity lost on Hurricane Harvey, meaning that crude oil usage and gasoline production remain below-par.