Fed stays hawkish, flags monthly bond unwind of $95 billion

7 Apr 2022 , 09:54 AM

When the recent FOMC meeting concluded on 16th March, the stand on rates was clearly hawkish. Fed had hiked rates by 25 basis points in March and had committed another 6 rate hikes in 2022. However, the minutes of the FOMC meeting, published on 06th April suggest that the Fed also plans to unwind the $9 trillion bond book at the rate of $95 billion per month. That is twice the 2017 run-rate.

The Fed minutes clarified that the Fed would commence the process of winding down its $9 trillion balance sheet. The actual approval for the winding down will be taken at the next FOMC meet on May 03-04. The monthly winding down would be something like this.

Monthly Winding Down	Treasuries	Mortgage Backed Securities	Total Monthly Unwind
Starting from May-22	$60 billion	$35 billion	$95 billion

The above amounts would be the caps and these will be open to modifications based on market conditions. However, this average monthly unwinding would be nearly twice the unwinding done in the last round in 2017-19, when it was $50 billion a month.

CME Fedwatch shows more certainty of early rate hikes

One indicator of the probability of rate hike and its timing is CME Fedwatch. Here are the implied probabilities of different Fed rate scenarios over the next 7 Fed meetings.

Fed Meet	50-75	75-100	100-125	125-150	150-175	175-200	200-225	225-250	250-275	275-300	300-325
May-22	21.2%	78.8%	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil	Nil
Jun-22	Nil	Nil	14.5%	60.7%	24.8%	Nil	Nil	Nil	Nil	Nil	Nil
Jul-22	Nil	Nil	Nil	5.7%	32.8%	47.2%	14.3%	Nil	Nil	Nil	Nil
Sep-22	Nil	Nil	Nil	Nil	4.0%	24.5%	42.5%	24.5%	4.5%	Nil	Nil
Nov-22	Nil	Nil	Nil	Nil	Nil	3.6%	22.8%	40.9%	26.1%	6.2%	0.4%
Dec-22	Nil	Nil	Nil	Nil	Nil	Nil	3.5%	22.3%	40.5%	26.5	7.2%
Feb-23	Nil	Nil	Nil	Nil	Nil	Nil	1.0%	9.0%	28.3%	37.2%	24.6%

Data source: CME Fedwatch

Normally a probability in the range of 25% to 30% is a strong indication of affirmative action.

• With the first rate hike done in Mar-22, the markets are pencilling in an 80% likelihood of a 50 bps rate hike by the Fed in the forthcoming May 2022 FOMC meet.
• By June 2022, the bond futures are building in a strong likelihood of rates rising by 125 bps to the range of 1.50% to 1.75%.
• By December 2022, the Fed futures probabilities are making the case for a total of 225-250 bps rate hike, with probabilities trending higher since the Mar-22 FOMC meet.
• If you look at the longer term projections, the Fed is now pegging the rates to go all the way to above 3.25% over the next one year to stem the rampant rise in inflation. .

As the Fed has spoken in hawkish tones, the CME Fedwatch (an indicator of Fed Futures trading) is hinting at market view being most hawkish in recent memory.

What we gather from the minutes of the Mar-22 FOMC meet

The Mar-22 FOMC meet was explicit about 6 additional rate hikes in 2022. Now, the minutes make 2 more things clear. Firstly, hawkish action by the Fed would be more intense than the hawkish statements. Secondly, the Fed will look to magnify the impact of the rate hikes by synchronizing with the bond book unwinding.

a) The outer trajectory of peak interest rates, pegged at around 2.75%, has now been unofficially raised to 3.25%. The markets see Fed being more hawkish than anticipated to curb consumer inflation; still rampant at 7.9% in Feb-22.

b) The minutes indicate that most members of the FOMC were inclined towards a 50 bps rate hike in March but refrained due to the Ukraine situation. However, the market consensus now appears to be of 50 bps rate hike May 2022.

c) The Fed is also expected to raise the pace of rate hikes with; possibly multiple 50 bps rate hikes with targeted interest rates around 2.75% by Dec-22. That could have strong ramifications for other economies in terms of monetary divergence.

d) Fed proposes to magnify the impact of rate hikes by combining it with unwinding of the bond book at the rate of $95 billion per month. The bond book had doubled to $9 trillion amidst liquidity infusion during the COVID-driven economic slowdown.

e) While the Fed had already dropped the word “Transitory” to describe consumer inflation about 4 months back, the minutes of the Mar-22 FOMC meet make it amply clear that the entire focus of the Fed in the short term would be towards fighting inflation.

f) The Fed minutes refer to a few jumbo rate hikes of 50 bps each in the current year, which is necessitated due to the Fed being way behind the curve on rate hikes. With inflation at 7.9%, the real bond yields are deeply in the negative zone.

g) According to the Fed minutes, the first target for the Fed would be to move to a neutral Fed rate of 2.40%; nearly 200 bps higher from current levels. It is only at this level that the Fed would even rethink its strategy and this move could happen rapidly.

h) The one factor that could circumscribe bond book unwinding decision is the inversion of the US yield curve. The 2 year yields went above 10-year bond yields; a signal of negative GDP impact of rate hikes at the longer end. It is not yet clear how the Fed reacts to this economic data point.

Mar-22 Fed minutes could be a call to action for India

There are 3 key takeaways for India from the Mar-22 Fed minutes.

• Indian bond markets have to be prepared for a monetary and capital flow shock if the US really gets aggressive on rate hikes. They are talking about another 200 bps rate hike over 6 FOMC meetings. India must be prepared for bond market volatility.
• India would be worried if the US Fed goes through with its $95 billion monthly bond unwinding. Liquidity impact is harder to tackle, since it would suddenly dry up the all-important passive flows into Indian financial markets.
• For now, the Fed appears to be obsessed more with inflation than with GDP growth. If the yield curve inversion becomes a credible signal, the narrative could change back to growth. At least, that is something, India would be seriously hoping for.

For now, the focus shifts on the RBI monetary policy on 08th April.