Federal Reserve Chair Janet Yellen will deliver her semi-annual testimony to Congress today and tomorrow at 15:00 BST. Below we take a look at the key things to watch out for from her testimony and the potential market impact.
Balance sheet vs. interest rate hikes
Yellen’s Fed colleague Lael Brainard said this week that she is close to voting for a reduction in the size of the Fed’s balance sheet, however, the Fed could be coming to the end of its rate-hiking cycle. This is crucial for the bond market and the dollar. If Yellen sends the same message later today this could be considered less hawkish than some expect, and we could see Treasury yields tumble dragging the dollar lower with it. However, it would be fairly good news for stocks and for emerging markets, which could be hit hard if Yellen suggests that the Fed’s balance sheet could be unwound quickly at the same time as the Fed hikes interest rates.
Balance sheet reduction details
The minutes of the last Fed meeting did not give much away regarding the timing and process of reducing the Fed’s huge balance sheet. If the Fed is set to announce that it will start scaling back its balance sheet as soon as this month’s meeting (we actually think that September is more likely) then she may use this week’s testimony to release some more details such as when it will start to happen and how the Fed will go about it. Will they start by stopping reinvesting the proceeds of all assets? How long before they start selling assets? Will they concentrate on one sector first, for example mortgage-backed assets, or commercial assets? These are all very important questions not only for the various sectors of the bond market, but also for the stock prices of companies that could be affected. For example, if Yellen makes any suggestion that mortgage-backed securities will be sold off first then this could hit the stock price of the US real estate sector.
Emerging markets
There has been a lot of concern about the impact reducing the Fed’s balance sheet could have on emerging markets. The latest Bank of International Settlements (BIS) report sounded concerns about emerging market credit levels as the Fed takes steps to reduce their balance sheet. Emerging market non-bank borrowers have amassed more than $3 trillion of dollar denominated debt, according to the BIS. Countries with the most outstanding US debt include Brazil, Turkey and South Africa. However, it’s not all bad news for EM bond markets as some investors, including HSBC (LON:HSBA), have actually become bullish on the outlook for local currency emerging market bonds as the dollar has fallen in recent months. But, demand for local currency debt could well reverse if the dollar picks up again. However, it highlights the dichotomy between talk of consequences for emerging markets from a Fed taper, and investor inflows. For example the MSCI Emerging Markets Equity Index (NYSE:EEM) continues to rise and is at its highest level since 2015.
The US economy
We expect Yellen to sound fairly upbeat on the US economy and the labour market after last month’s decent jobs figure and the upward revisions to some previous months. However, her outlook on inflation, which is expected to fall to 1.7% in June from 1.9%, could be an obstacle to the Fed’s hawkish course of action. We believe that if Yellen does suggest that the balance sheet reduction will come at the expense of interest rates then her testimony could be considered as dovish. Of course, the opposite is also true, especially if Yellen hints that a balance sheet reduction programme could start in a matter of weeks and a rate hike is coming in September.
The Fed vs. the market
The market has consistently underestimated the Fed’s intention to raise interest rates. The Credit Suisse (SIX:CSGN) Deviation index, which measures the basis point difference between market rates and the Fed’s dot plot, sees the market expecting 2.3bps less of tightening this year than the Fed expects. The market expects significantly less tightening from the Fed next year, so will Yellen try to narrow this gap by sounding hawkish and shocking the market into believing that the Fed means business when it comes to normalising monetary policy?
The market impact
This will all depend on whether Yellen sounds more concerned about weak prices, or if she says that the balance sheet can shrink at the same time as rate rises. If Yellen sounds particularly concerned about prices, which would echo fears also voiced by Brainard on Tuesday, then we could see a sharp reversal in US bond yields, more woe for the dollar, and potentially some uplift for stocks. If she sounds more upbeat, and hints that a rate rise could come hot on the heels of an announcement of balance sheet reduction, then we could see yields rise along with the dollar and stocks suffer.
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