FOREX TRADING

A Roadmap for the Fed’s Exit

• The Fed is moving towards an exit of its very easy monetary policy, and the first steps to reduce liquidity have already been taken There are several more steps on the road to the first fed funds rate hike, but the Fed will prepare markets well in advance.
• The unwinding of alternative easing measures has so far been smooth and we see the biggest risk for a destructive market reaction from the termination of the MBS/Agency purchase programme by end March. A surge in mortgage yields could potentially delay the first rate hike.
• Fundamentals would call for an unchanged fed funds rate through 2011, but given its extremely low level, the first hike is expected to arrive late this year. That said, the Fed will be cautious not to tighten too aggressively and is likely to pause hiking close to the 1% level in 2011.

Exit already in progress

This week a testimony by Chairman Bernanke to the House revealed the Fed has progressed further in its move towards the exit. During the crisis the Federal Reserve System implemented several alternative policy measures to cope with the seizure of money market liquidity and to ease financial conditions for the real economy beyond what could be obtained by a zero interest rate policy. With signs of an economic recovery becoming increasingly convincing, the debate about how and when the Fed will tighten monetary conditions has intensified.

While the Fed will not fully complete its purchase programme for mortgage assets before 31 March, the unwinding has already begun. By 1 February, most short-term liquidity and some lending facilities were terminated. Further, the Fed has laid out a plan for the unwinding of the remaining liquidity and short-term lending programmes. According to this plan, all these measures will be terminated by end H1, as illustrated by the timeline below.

We still don’t know when the Fed will start to drain excess reserves in the fed funds market and when the Fed will start traditional tightening in terms of interest rate hikes. However, we think that the completion of the mortgage asset purchase programme by 31 March will mark an important point. Following that date, the Fed will slowly start to prepare the ground for monetary tightening. This progress is likely to be very gradual and happen in small and well-advised increments in order to avoid spooking the markets. We think the following order of events is the most likely based on recent Fed communications.

1. Prepare the market to drain excess reserves by increasing the spread between the fed funds rate and the discount rate.
2. Prepare the market for hikes by removing ‘extended period’ language.
3. Excess reserve draining operations.
4. Interest rate hikes.

The timing of these events is likely to be subtle. Our best guess is illustrated in the timeline above, but the sections below will provide more details about the relevant considerations on timing and implementation.

Unwinding of alternative easing measures

The alternative easing measures can broadly be divided into liquidity providing measures, aimed at securing a smooth functioning of money markets, and credit easing measures, targeted at specific dysfunctional credit providing markets. On top of this, the Fed’s asset purchase programme served the purpose of both putting downward pressure on longer term yields and adding liquidity to the system.

Most of the credit easing and liquidity programmes were designed with a penalty rate. Hence, as market conditions improved and the market was flooded with liquidity from the Fed’s asset purchases, they largely unwound automatically. The impact on money markets from the termination of the liquidity programmes is thus minor. The same is true for the credit easing measures, where the use of the facilities has generally declined in line with the healing of financial markets.

The bulk of the increase in excess reserves can be attributed to the agency/MBS purchase programmes. This implies that in order to normalise the amount of liquidity in the system and get a better anchoring of money market rates, the Fed needs to take measures to actively drain liquidity.

While one possible solution would be to simply sell the assets accumulated from the purchase programmes, this would risk sending mortgage rates substantially higher and damaging an already fragile housing market recovery.

The Fed has indicated that it would prefer to drain liquidity through reverse repos – i.e. swapping assets for liquidity temporarily. This would not shrink the Fed’s balance sheet but would merely shift the composition from MBS/Agency/Treasury securities to a large holding of repos. In addition to this, the Fed is flagging the idea of implementing term deposits. Term deposits would pay a higher interest rate than excess reserves (currently equal to the upper level of the interval for the fed funds rate (25bp)) and hence raise the incentive to tie up liquidity at the Fed for a longer period.

One caveat is the arbitrage possibility from borrowing at the term Discount Window at the fed funds rate plus 25bp and placing it on term deposit at the Fed at a higher rate. To prevent this the Fed has indicated that it will increase the discount rate spread sooner rather than later. Importantly, the Fed has clearly signalled that this should not be interpreted as signalling any change for the monetary policy outlook, but merely be considered a normalisation of liquidity facilities.

Another positive spin-off is that a discount rate hike will encourage market participants to exchange liquidity through the market place instead of borrowing at the Fed, and hence discourage banks to add even more excess liquidity to the system. Although we expect that the above measures will be implemented before the first Fed hike, the amount of excess reserves is likely to stay elevated throughout 2010 and possibly into 2011. It will thus be difficult to keep short term money market rates at the target Fed funds rate without raising the rate paid on excess reserves (IOER), and we believe they will have to move in tandem going forward. Alternatively, the Fed might choose to communicate its policy stance through the IOER or another alternative shortterm rate.

Higher mortgage rates could be a show-stopper

While the unwinding so far has been smooth, the biggest risk for a destructive market reaction remains attached to the termination of the MBS/Agency purchase programme. It is extremely difficult to assess what the exact impact on mortgage rates will be. One comforting factor is that the Fed has already started to scale down purchases without any major impact on mortgage rates. The real test however is 31 March when the purchase programme will terminate.

Part of the spread tightening of agency-backed MBS’s to government bonds through 2008 and 2009 is likely attributable to a more explicit government guarantee, as the agencies were put under conservatorship in September 2008. However, the major effect on mortgage lending rates came from the Fed’s asset purchase programme. In the first months following the Fed’s start of the MBS/agency purchase programme, the spread between the 30-year Freddie Mac mortgage lending rate and the yields on a 30-year government benchmark tightened more than 100bp.

In a speech on 14 January, New York Fed president Dudley stated that the end of the Fed’s purchases of mortgage-backed securities is “going to have a relatively small effect on the level of mortgage rates, something in the order of 0.5 to 0.25%”. Hence, if mortgage rates were to back up substantially more than this, it could potentially delay the path for the Fed exit scheduled above, and in an extreme case make the Fed extend the MBS purchase programme.

Preparing the markets for a hike

However, if things develop in an orderly fashion, the next step will be traditional tightening in terms of rate hikes. As always the timing is subtle – perhaps this time more than ever – as there are valid arguments for both early and late hikes. That said, hikes are not likely to arrive without proper advertisement by the Fed. For now the FOMC statement clearly communicates that fed funds rates will remain exceptionally low for an extended period

According to the New York Fed President Dudley in a PBS interview on 13 January:

“…extended means at least six months. It could be a year from now, two years from now. It’s going to depend on how the economy develops”

Other Fed members have been indicating a slightly shorter time span of 3-4 months. However, we believe that an important milestone for moving toward traditional tightening is that the ‘extended period’ phrase is removed about 6 months ahead of the initial rate hike, as illustrated in the timeline on the front page. Given our view, that this will arrive in November, we look for the ‘extended period’ to be removed from the statement before mid year.

The rephrasing of the statement is likely to be an incremental process, where the language is gradually twisted, as was the case ahead of the beginning of the hiking cycle in June 2004 (see illustration to the right).

The timing of rate hikes

In general we find three approaches relevant for considering the timing of the hiking cycle.

1. Speed limit approach
2. Output gap approach
3. Judgement based factors

A speed limit approach takes into account the speed of the recovery in the economy. A simple way to do this could be to see how fast the unemployment rate peaks following the recession. If the economy turns fast, the unemployment rate will peak early in the recovery and then tightening should begin sooner.

However, it may be too narrow a framework to only consider the unemployment rate. We believe that the Fed is generally concerned with other factors such as core inflation and credit growth.

In the table above we have recorded the time span from the end of the recession to the peak in the unemployment rate, the trough in annual core CPI, and the trough in the annual growth rate of bank credit, respectively. The sum of these three measures we define as the Hike Score. The faster the indicators on unemployment, inflation and credit recovers, the lower the Hike Score and the earlier the Fed is likely to tighten. The cross plot above compares the Hike Score to the number of months from recession end to the initial hike.

In the current cycle we believe that a peak in the unemployment rate and a trough in the annual growth rate in bank credit has already been established (see table above). Assuming that the recession ended in July 2009 and that core inflation will peak in December 2010, this exercise suggests that the Fed should begin tightening around yearend 2010. In fact this is not far from our forecast.

Output gap based approaches are anchored in the amount of slack and the degree of price pressure in the economy. Based on such a framework it seems as if the Fed has plenty of time to normalize interest rates with an unemployment rate close to 10% and core inflation heading below 1%.

One way to illustrate this is to apply a standard Taylor rule on core PCE inflation and the unemployment rate. Based on the current data, this rule prescribes a deeply negative policy rate around -4% to -5%. Given our forecast for core inflation and unemployment, the rule remains negative through the entire 2011. This is also the case if we use the FOMC’s own economic projections.

However, as Federal Board Vice Chairman Kohn emphasized in a speech at 3 January: “…because monetary policy typically acts with long lags in the economy and price level, the choice of when and how to exit will depend on forecasts. We will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization.”

Hence the FOMC is likely to be more forward looking than a standard Taylor rule. Given a monetary policy lag of 9-18 months, rate hikes may arrive up to 1.5 years ahead of the Taylor rule according to Kohn. When based on members current central range forecast the Fed is not likely to initiate the hiking cycle before well into 2011 – even under a forward looking approach.

An alternative to the Taylor rule is to estimate a reaction function on economic and financial variables. This is demonstrated in the chart above. Our preferred 12-month forward reaction function for the Fed is supporting the message from the Taylor rules – that hikes could remain off the agenda until well into 2011.

On top of these considerations, several other non-quantifiable factors are relevant. Such factors are usually subscribed to the discretionary judgement of the policy makers.

Firstly, the extreme low level of interest rate is generating concern among some Fed members. These concerns include potential risks for asset bubbles, misallocation of capital, an un-anchoring of inflation expectations and a loss of inflation fighting credibility. Due to these considerations some members in the FOMC are clearly pushing for rate hikes at an earlier stage of the recovery than usual.

Secondly, other policy factors such as fiscal tightening and regulation could affect the decision about when to hike interest rates. If fiscal policy is tightened significantly or if very tough regulation is implemented, this could crowd out monetary policy tightening for a while. We believe that this is a very relevant risk for 2011.

Fed to hike earlier than usual

In conclusion the evidence is very mixed, but we believe that the extremely low level of interest rates may call for hikes to arrive at an earlier stage than warranted by the slack in the economy. This would make some FOMC members feel more comfortable about inflation and bubble risks and it may make it easier to absorb excess liquidity. However, because of the extreme degree of slack in the economy and the prospects of fiscal tightening and financial regulation, we believe that the Fed will be very cautious not to tighten too aggressively during 2011.

Our current forecast assumes that the Fed will hike interest rates to 0.5% at the November 2010 meeting and by a further 25bp at the December 2010 and January 2011 meetings. These hikes will reflect more a desire to move away from zero interest rate policy than the beginning of a long-lasting tightening campaign. Hence, we find it likely that the Fed could pause around 1% in early 2011 to assess the outlook and wait for the slack in the economy to diminish before the real tightening cycle begins.

Danske Bank
http://www.danskebank.com/danskeresearch

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets´ research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.