The main points of the Fed… While the main points of the Fed's move on Wednesday will be 75 bps or 100 bps interest rate hikes, the main point will be the terminal rate assumption and the details to be given about the balance sheet content rather than the speed of the rate hikes. It is also important when the Fed, which started the QT trend on paper by shrinking its balance sheet as of June 1, will switch to active balance sheet asset sales or whether it will make such a strategy adjustment in order to increase the effects of the tightening.
Balances in the real economy… The possibility of a 100 bps rate hike will probably be less probed by the Fed right now. Because the possibility of an excessively moving Fed to drag terminal rates to unsustainable levels will give the perception that the recession risk is also underestimated in the economy. Fed tightened late by misreading the inflation risk, now it's tightening too much by misreading the risk of recession. Within the framework of 75 bps, 80% swap pricing in July, it seems more reasonable under the following conditions. In an environment where economic activity is slowing faster than expected and pressure is growing, pushing the uncertainty band too far will likely damage the relevant indicators more.
Fed funding rate and balance sheet assets comparison… Source: Bloomberg
Financing risks… The ECB increased interest rates by 50 bps, but it is technically not possible to sustain top level increases due to recession risks. From financing risks to real sector risks, there will be an uncertainty deepening the activity stagnation in many branches. For the Fed, the situation is as follows; Although the analyzes show that the potential of the US economy to be affected by the energy crisis is low and the employment market is strong, it shows that the production and input difficulties of the US in foreign markets cannot be avoided without slowing down. We can add to this the possibility of slowing down investment and employment by considering the uncertainties in the financing conditions of the companies and the real economy.
Balance sheet strategy… As of June 1, the Fed started to shrink its balance sheet of 9 trillion dollars in order to mobilize liquidity. The central bank has purchased roughly $4.6 trillion of Treasury and mortgage-backed securities through quantitative easing over the past two years to maintain longer-term interest rates. The process, also known as QE, resulted in an increase in bank reserves.
When Treasury securities held by the Fed become due, the Fed holds fewer assets (Treasury securities decrease) and has fewer liabilities when the Fed does not reinvest the proceeds of the securities that are due and the Treasury does not issue new securities. At the end of this period, the Fed's balance sheet size will shrink as Treasury bonds decrease on the asset side and reserves on the liabilities side. It is possible that the Fed will accelerate this contraction rate by emptying the MBS portfolio faster.
Conclusion? In this pricing environment, an increase of 75 bps will have a FOMC effect that will not create a surprise variable effect, and a 100 bps increase will have a hawkish FOMC effect. If the market moves towards a Fed perception that ignores a recession for inflation, the yield curve asymmetry will deepen. In such an environment, it will be more likely that 2-year yields will continue to rise, rather than 10-year yields. It should be kept in mind that even in this state, the Fed is in the perspective of the highest tightening since the Volcker era. Inflation continues to be the most important concern of policy makers, and it will be necessary to pay attention to the details of the gradual situation regarding the growth outlook and rate of interest.
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