Posted in Client Conference Calls, Samples

The Mechanics of Balance Sheet Normalization


  • For Treasuries the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
  • For agency MBS the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The interactive chart below shows maturing Treasuries by month, along with the evolution of the cap on reinvestment. Mouse over the bars for each month to see the amount to be reinvested. 

The Fed will continue reinvesting Treasury proceeds each month until through August of 2018. Reinvestment will then occur almost exclusively during February, May, August and November.

Though the final size of the balance sheet has yet to be determined, the Fed has estimated that normalization will occur sometime in 2021-2022.


Estimating the reinvestment of agency MBS is more complex. Mortgage prepayments will vary with the level and path of interest rates, as well as the pace of home sales. The graphic below is from the Wall Street Journal and reflects the expected path of reinvestment given current rate forecasts.
As long as interest rates do not fall sharply, reinvestment of MBS proceeds would end in late 2018 as prepayments fall below the cap. A sharp drop in interest rates would see prepayments rise as consumer refinanced mortgages. That would result in larger sums being reinvested in earlier months. 


Posted in Client Conference Calls, Samples

Growing Risks from Fed’s Focus on Financial Conditions


The chart below shows the Goldman Sachs U.S. Financial Conditions Index with bands indicating prior Fed tightening campaigns. The sustained loosening of financial conditions is unique to this tightening campaign. Driven in large part by persistently strong equity market returns and a weakening dollar, this behavior has confounded markets and Fed officials. 



Our own measures of credit conditions, highlighted on September 6, are in agreement. The chart below shows two measures of financial conditions, deposits, and lending (light blue) and financial leverage (red). We view levels below the gray shaded area as too expansionary. Warning signs are already flashing for financial leverage while deposits and lending are approaching the lower band of acceptable. This could easily steer the Fed toward continued tightening despite inflation data that is expected to remain weak in the near term.



We have argued that the Fed should discount loose financial conditions, heavily influenced by strong equity markets and the weak U.S. dollar, and be mindful of the signals from the treasury curve. While still at 80 bps, the 2y10y spread is testing key lows. 



We discussed on September 6 how the neutral rate has fallen and may be well below where many Fed officials believe. Upcoming changes in the FOMC are at play here as well. The unexpected departure of Stanley Fischer in October will place more influence in the hands of remaining experienced officials. Thomson Reuters has a graphic showing the hawkish versus dovish views of each member, ranked by their perceived influence. William Dudley, proponent of financial conditions as a policy guide, and Lael Brainard, who views a falling neutral rate as a important risk, are presented as the second and third most influential behind Yellen. Each will be vying for support for their views among new officials. 

The next chart is one we have shown several times. This shows the probabilities of a contraction in deposits and lending growth at varied levels of core inflation. Economic conditions are held constant. We believe the June hike likely sent the fed funds rate above the reversal rate, a point where tightening will begin to impact financial conditions. Without stronger economic growth, further tightening will likely induce a contraction in lending growth. 



The next chart shows the probability of a contraction based on the level of the Fed Funds target rate. We believe that we are near or past the reversal rate where additional rate hikes will tighten financial conditions. 



What can we expect if this happens? 

The chart below shows estimated 12-month returns by increasingly tighter deposits and lending conditions (left panel) or financial leverage (right panel). U.S. 30-year bonds are most heavily impacted (bullishly) by tightening deposits and lending conditions (dark grey line, left panel).

A lack of inflation coupled with credit contraction could create a scenario capable of further flattening the U.S. Treasury yield curve. 




Posted in Client Conference Calls, Samples

Balance Sheet Reduction, Who Else Will Join the Chorus?


The great unknown is when other central banks will join the chorus. Hawkish rhetoric is on the rise outside U.S. borders. But, action speaks louder than words…

The direction of equity returns have remained dictated by economic growth, however insulation to negative developments and a positive beta to positive developments have very likely been provided by continued monetary stimulus across the globe.

What if economic and inflation growth were allowed to mechanically determine the impending unwind of Fed, ECB, BoJ, and PBoC balance sheets?

The chart below shows forecasts for 2018 through 2019 based on major economic and inflation data releases.

Quick takeaways:

  • Eurozone’s recent economic improvements suggest a much lower balance sheet by the end of 2019 near $3.05T
  • US’ slower pace of gains points to a modest $0.88T reduction over the same time frame
  • Continued lack of inflation in Japan indicates the BoJ’s balance sheet could continue rising toward $5.13T
  • PBoC is expected to maintain a stable balance sheet near $4.88T



The next chart shows the same forecasts, however stacked to indicate totals across the big four central banks. Total balance sheet assets are expected to drop from a current $19.1T to $16.6T by November 2019. In reality, a drop of $2.5T is quite marginal. Investors seemingly understand the process of ‘normalization’ will be a long one, especially in the event a recession were to hit in the coming five years.

What could make this change? Easy, inflation.



Core inflation remains a laggard across most economies. Only Sweden appears primed to become a first-mover for economies dealing with negative interest rates. The chart below shows OECD composite leading indicators versus CPI less food and energy YoY through July 2017. Sweden’s central bank is nearly alone in the upper right quadrant meaning they are dealing with inflation above target while their economy is expected to continue growing.


Sovereign yields have become increasingly attached to changes in total assets held by the big four central banks. The scatterplots below show 60-day log changes in total assets versus returns for U.S. and German 10 year sovereigns since 2016.

A continued rise in the BoJ’s balance sheet will likely be washed out by a reduction by the Fed. What Draghi decides for the ECB is likely most important for yields going forward. An ECB reducing assets alongside the Fed in 2018 would bring down total assets held by the big four central banks and finally drive yields higher.


Posted in Client Conference Calls, Samples

U.S. Inflation Expectations Rebounding with Economic Surprises



U.S. inflation expectations should continue to rebound in the event economic data surprises (beats) make a triumphant return. History suggests TIPS breakevens widen with great frequency after a period of extreme data misses.


Inflation remains the dominant topic for the Fed and market participants. The chart below shows the percentage of T.V. news coverage of the Federal Reserve including each category (inflation, uncertainty, and financial stability). However uncertainties including political and financial stability concerns are rapidly on the rise. Do not forget the Fed continues to suffer from short-term-ism.


The Fed’s potentially hidden mandate of financial stability is again rearing its head. The next chart shows counts for ‘leverage’ or ‘volatility.’ Excessively easy financial conditions are likely heavily on their minds.

The likely slow trickle of balance sheet reduction will keep markets fixated on potential rate hikes. Low inflation has likely driven down the neutral rate to approximately 125-150 bps by our own calculations. Another hike (or more swift reduction in the balance sheet than expected) would cause the first tightening in financial conditions during this cycle. A contraction in deposits and lending growth shows a real potential to further flatten the U.S. Treasury yield curve, which is not favorable for the economy. 



The Fed wants to maintain a long-term focus to avoid getting tripped up by transitory and/or short-lived forces. However, their own use of ‘long-term’ versus ‘short-term’ in speeches and other releases indicates a short-term focus persists following the financial crisis. 


The Federal Reserve had never pushed their models and projections as much as they did during the spring of 2017. Lagging inflation relative to employment is seemingly not due to transitory forces. This conundrum is forcing economists and Fed officials to question the Phillips Curve and historical relationships between wages and the approach of full employment.

Not surprisingly, Fed officials have recently diminished the frequency of model and forecast comments (top panel). Notably, the uttering of ‘confidence’ has also tumbled (bottom panel).



Inflation surprises (i.e. beating economists’ estimates) in the U.S. have been very difficult to come by following the financial crisis. The chart below shows Citigroup Inflation Surprise indices for major economies with values above zero indicating beats and values below zero indicating misses.


In fact, the U.S. is at the bottom of the list of economies producing inflation surprises since 2012. Only three months (4%) have seen the U.S. inflation surprise index above zero. No wonder Brainard and some other Fed officials are leaning toward inflation running hot above 2% before further tightening. Current low levels of inflation have dragged the neutral rate lower, which we believe resides near 125-150 bps. Another hike in December and/or balance sheet reduction will very likely cause tighter financial conditions for the first time in this cycle.


So why are inflation expectations for the U.S. rebounding? We previously indicated U.S. 10-year TIPS breakevens have always widened after the U.S. Citigroup Economic Surprise index reached an extreme below -60, which occurred June 15th, 2017. Breakevens are 16 bps wider since this date.


We now look to expected moves by inflation expectations in the event the surprise index continues its rebound above zero, meaning a return to concerted data beats. The chart below shows past moves in U.S. 10-year TIPS breakevens days after the surprise index recovers from below -60 and breaks above zero.

U.S. 10-year breakevens widened 30-trading days later 78% of past instances by an average of 11.5 bps.


Posted in Client Conference Calls, Samples

Consumer Behavior Not Yet Reflecting Stronger Wages/Inflation


Stronger gains in inflation are being found near technology hubs like San Francisco, likely where job markets and wages are improving most. Consumer demand for discretionary goods and services have yet to rebound as much as non-discretionary, durable goods. The jobs market is still upbeat, which we hope will finally lead to wage pressure. This analysis dives into Google Domestic Trends to determine when this shift is occurring. 


The chart below shows CPI less food & energy by metro from 2006 to current. We have often cited technology as a headwind for inflation. However technology hubs, namely San Francisco, Atlanta, Los Angeles, and Seattle, are seeing higher core inflation and producing a positive skew to overall inflation.




The chart below shows YoY changes in google trends for ‘inflation’ by metro area. Over 70% of these major metro areas show growing interest and potentially concern about inflation.


The percentage of metros seeing inflation (bottom panel) trending appears to lead core inflation (top panel) by approximately 18 months. The Federal Reserve often cites expectations of businesses and consumers as a driver of inflation.


But, consumers need jobs, higher wages, and ultimately higher spending to help fuel inflation. We measure consumer behavior via Google domestic trends. Google domestic trends offer a window into consumer behaviors via rigorous analysis of Google searches.
Consumers remain upbeat concerning the job market as evidenced by a rising spread between job and unemployment-related search trends (chart below). 


Unfortunately, consumers are not yet seeing a strong rise in discretionary spending (e.g. travel and luxury goods) when compared to the basics (e,g, durables and insurance). The top panel in the chart below shows seasonally-adjusted YoY changes in trends attributed to discretionary spending. The bottom panel shows the same, but for non-discretionary spending.


The spread between the discretionary and non-discretionary indices above is a leading indicator for core inflation. A rebound in consumer behavior toward greater spending is likely needed to reflect improving wages.
All in all, we are awaiting a rebound in both witnessed inflation and then increased discretionary spending before fully committing to a robust environment for inflation.