A relief or a renew anxiety for the market?
The FOMC initiated its well-telegraphed balance sheet adjustment in line with the earlier guidance from its June 2017 meeting yesterday.
The key take away from yesterday Yellen’s speech:
- The FOMC confirmed that balance sheet reduction at $10bn per month will begin in October 2017. Adding $10bn per quarter to a maximum of $50bn per month. By end of 2017 it will reach $30bn, by end of 2018 will be $420bn and by end of 2019 will $ 600bn/year.
- Rate outlook : the Fed still predicts one rate hike in 2017 and three in 2018, albeit contingent upon positive surprises in inflation data in the coming months which the market interpreted as hawkish.
- Inflation : The FOMC continues to see inflation being on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term.
- There is around $2.5tr of excess reserves by depository institution in Fed liability side of balance sheet, meaning the Fed is planning to take about 4 years to normalize.
- Now with the balance sheet adjustment underway, the Fed will assess the impact of the shift and closely monitor inflation developments in the coming months before deciding on the next move.
- Overall, this configuration does not seem risk negative. In response this morning, Asian markets are seeing a relatively modest impact in equities and credit/bonds. Despite slightly more hawkish message in yesterday’s statement, the US dollar did not rally further.
- Fed fund futures now suggest about a 65% chance of another hike this year – up from 50% pre-FOMC – and about 44bp of cumulative hikes by the end of 2018 – up from 39bp pre-FOMC.
- Given 2017 returns in EM have been driven by prolonged USD weakness; inflows to EM have been around USD 100bn and this amount is likely to feed back to the US in the form of greater price pressures and higher rate expectations, which will in turn serve to slower flows into EM, in our view.
- Domestically, more important to watch will be the Bank Indonesia meeting today where expectations for a rate cut are split 50-50. Should policymakers deliver a rate cut following yesterday’s FOMC, we would expect to see some weakness in IDR.