The Fed may be headed for a clash with Trump...but not over interest rates

Published Wed, Jan 18 20175:22 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

The bond market can't help but worry that if Donald Trump succeeds in stimulating the economy, it could mean he will have a new reason to clash with the Fed. That's because if growth picks up, the U.S. central bank will move faster to normalization, not only by raising rates, but by addressing its sleeping giant of a balance sheet. Fed officials, since their last meeting, have been talking about the day when they will stop holding onto the $4.5 trillion in Treasury and mortgage securities in their portfolio, and allow them to roll down. The Fed now replaces securities when they mature, but if it were to stop, the Treasury would have to pay back the Fed. Bond strategists say the impact of that would be rising rates in the Treasury market and a widening of spreads on mortgage securities, which would translate to higher rates for homebuyers. Meanwhile, President-elect Trump plans to stimulate the economy with a big fiscal package and tax cuts. It's unclear how much the administration would use debt to fund its programs, but there is some amount of new borrowing expected. "If the Fed does start to reduce some reinvestments, and interest rates rise and rates become high enough Congress could become uncomfortable with the prospect of borrowing more money. Maybe stimulus doesn't go through as planned," said Tom Simons, money market economist at Jefferies. "All these things have the market bulled up for increased growth in the future, but it's possible the Fed by reducing the reinvestments could present more difficulty for the fiscal policies to go through." Tensions could really pick up in 2018. That's when about $422 billion in Treasurys are slated to roll down, more than double the $195 billion this year. About $2.45 trillion of the Fed balance sheet is Treasurys. Repayment for the $1.7 trillion in mortgages held by the Fed is more difficult to predict since there are prepayments. "They made some vague reference to various circumstances under why they would need to adjust the size of their portfolio as they adjust the fed funds target rate," said Mark Cabana, head of U.S. short rates strategy at Bank of America Merrill Lynch. "Our thought is probably in the second half of 2018, they make some adjustments to their reinvestment plans, but there's certainly risk they do it sooner," said Cabana. "When that happens, it matters for the mortgage market and the Treasury in terms of what they need to fund. They would probably fund most at the front end of the curve but it's a fair amount of additional supply they will need. That would put pressure on rates." Cabana said the Treasury would probably help the Fed push through some organized pay downs. That would be easier to schedule than for mortgages, which fluctuate with prepayments. "If the Fed were to reduce the size of their balance sheet, they would be reducing the level of accommodation they provide to the marketplace. That's a tightening of policy. You would expect markets would not be too happy about that," Cabana said. "But the Fed hasn't really provided any specifics about what they're thinking about this. We've had a few Fed officials saying they want to accelerate the conversation about this." The central bank long ago stopped outright additions to the balance sheet through asset purchases, or quantitative easing, but it never pulled the plug on the program to replace securities as they mature. That allows the Fed to continue to keep easing, suppressing long-term rates while continuing to provide a higher level of stimulus. Simon expects the Fed to taper, or reduce the program gradually. Discussion of reducing the balance sheet first showed up in the minutes of the Fed's last meeting. Since then, several Fed officials have discussed the idea, and a number of market strategists have dissected the topic in notes. "I think they want to get this entrenched in people's minds well before this is going to happen. I think they're probably just sending up some signals. Some white smoke is floating in the air. When it becomes black smokes it means they're going to go. We know the furnace has been lit," said Jim Caron, fixed income portfolio manager with Morgan Stanley Investment Management. Caron said the Fed is trying to avoid another "taper tantrum," recalling the bond market reaction to the Fed's withdrawal from a bond-buying program. "I don't think it's a 2017 event," he said Caron said the Fed seems to want there to be a clear distinction between policy and its balance sheet so investors are not confused by its signaling. Another factor is the central bank will have a number of different members in 2018, including most likely a new Fed chair. "There could be six new people sitting at the Fed," he said. Yields rose Wednesday after Fed Chair Janet Yellen said the central bank could see rates increase gradually to 3 percent by 2019, as the Fed has currently forecast. The 10-year yield climbed to 2.40 percent after she spoke. Buying in Treasurys has picked up in the last couple of weeks and yields have come off recent post-election highs as investors weigh which policies Trump will be able to quickly implement when he becomes president and which ones will become victims of the D.C. legislative grind. The market also has been hedging against the idea that some of Trump's less market-friendly leanings, like tariffs, could gain more traction than expected. The 10-year yield reached a high of 2.64 percent on Dec. 15 amid optimism over Trump policy. Since then, yields have trended lower but edged up again this week as the market responded to Fed officials sounding more hawkish and more confident about the economy.

Federal Reserve Chairwoman Janet Yellen speaks to educators at the Federal Reserve Board Building January 12, 2017 in Washington, DC.

Aaron P. Bernstein | Getty Images

The bond market can't help but worry that if Donald Trump succeeds in stimulating the economy, it could mean he will have a new reason to clash with the Fed.

That's because if growth picks up, the U.S. central bank will move faster to normalization, not only by raising rates, but by addressing its sleeping giant of a balance sheet.

Fed officials, since their last meeting, have been talking about the day when they will stop holding onto the $4.5 trillion in Treasury and mortgage securities in their portfolio, and allow them to roll down. The Fed now replaces securities when they mature, but if it were to stop, the Treasury would have to pay back the Fed.