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At the close of its two-day meeting (19-20 September), the Federal Reserve announced that in October it will start shrinking its balance sheet, which stood at USD 4.505 trillion on 22nd September. The announcement comes almost nine years after quantitative easing began. The plan is to only partially reinvest principal payments from maturing securities. Initially, the Fed will invest money back into the market only if it receives payments exceeding USD 10 billion. From there, the threshold will rise by USD 10 billion every three months until it reaches USD 50 billion per month.
Investors had been expecting the announcement and details of the unwind plan were revealed in June. In fact, for investors this meeting was more about updating the FOMC members’ dot plot (interest rate forecast) as recent inflation releases continued to undershoot. Their median forecast is still for another 25 bps rate hike in 2017 followed by three further quarter-point hikes in 2018. However, the members lowered the number of expected rate hikes for 2019 from three to two.
By sticking to their interest rate forecasts for both 2017 and 2018, the FOMC members appear confident that the underlying inflation rate will recover in the months ahead, and this is a view we share. If this scenario materialises, the Fed will probably raise its benchmark rate in December. However, on 25th September, the markets only saw a 60% chance of an end-of-year hike. In addition, we believe that market expectations for 2018 and 2019 are too downbeat and that the Fed will be looking to raise rates according to the dot plot. Consequently, although the Fed’s soft approach to shrinking its balance sheet is, in itself, unlikely to drive rates sharply higher, we believe that market expectations for US interest rates are open to change, and all the more so given investors’ current enthusiasm for US bonds.
The opinion expressed above is dated 25th September 2017, and liable to change
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