Janet Yellen this week could tee up a stealth rate hike for later this year

As the market expects the Federal Reserve to increase rates three times this year, the central bank could put a fourth on the books in a way that's not so obvious.

An additional increase — call it a stealth hike — would involve a concerted reduction in the Fed's balance sheet. The balance sheet holds the various bonds and other financial instruments the Fed has purchased over the years, and it has ballooned to $4.5 trillion.

Under current policy, whenever a bond held by the Fed matures, it reinvests the proceeds it receives and rolls over the debt. By doing that, it keeps the central bank as a player in the bond market, which in turn creates demand and stifles supply to keep interest rates low.

Reversing the reinvestment policy, then, would have the opposite effect. Officials have begun some discussion in recent months about balance sheet policy but have not offered details or a timetable.

Some market participants think that could change Wednesday — if not from the post-meeting statement from the Federal Open Market Committee, then from Chair Janet Yellen at her news conference afterward.

"Chair Yellen has previously indicated that balance sheet reduction will occur once the FOMC has 'confidence the economy is on a solid course,'" Citigroup strategists Andrew Hollenhorst and Ebrahim Rahbari said in a note. "Any calendar or policy rate threshold guidance relative to market expectations of Q1 2018 would provoke a market reaction."

There aren't that many ways the Fed can surprise investors at this week's meeting. Traders assign a 93 percent chance that the FOMC will hike its benchmark borrowing rate a quarter point, and are now on board with officials' projections that two more moves are in the cards this year.

But substantial clues about the direction of the balance sheet would be one way to move markets, particularly if Yellen gets aggressive. The chair in the past has said a roll-off in the balance sheet would be worth two quarter-point hikes.

However, she's been cautious about pushing the case.

"Chair Yellen, and most others who have opined, have emphasized that the balance sheet should not be used 'actively' like short-rate policy, but rather that the accommodation being provided should be allowed to 'passively' dissipate," the Citi strategists wrote.

"In a recent speech (Fed Governor Lael) Brainard agrees but also raises the possibility that in some instances it may be preferable to remove accommodation through balance sheet reduction. We will be listening for any shift away from the 'passive' view and toward a more 'active' view," they added.

If Yellen indicates that the balance sheet will be used as a tool to tighten policy, that would be seen as a hawkish sign and could have substantial market impact.

The trader's perspective

Though running off the balance sheet could be an effective way of restoring rate policy to normal without having to actually hike, there are concerns that the Fed has mismanaged the situation.

In fact, some critics believe policymakers should have focused on rolling off the balance sheet first, which would have been a more effective way for them to achieve their goals.

"If you let the balance sheet start to run off, you'd see a rise in long-term interest rates. You'd have gotten an immediate steepening of the yield curve," said Peter Boockvar, chief market analyst at economic advisory firm The Lindsey Group. "The Fed did it somewhat backwards."

The Fed is holding $2.46 trillion in Treasurys and another $1.76 trillion in mortgage-backed securities.

If it had let some of the higher-yielding, longer-duration MBS run off, the Fed would have found a welcoming market, said Christopher Whalen, chairman of financial advisory firm Whalen Global Advisors.

"The problem is, they should be adjusting the balance sheet first. By keeping all of this duration locked up at the Fed, they're actually keeping rates artificially low, so there's no response to policy," Whalen said. "When they change the fed funds, the whole curve should move, but it doesn't."

Indeed, while the Fed has raised rates twice since December 2015, the spread between many maturities actually has narrowed.

Market participants worry that when the curve compresses so much that it inverts — with longer-duration yields lower than shorter duration — that historically has been a reliable sign for a recession.

"They're late. What they should have done was stopped reinvestment at the end of last year, mostly as a symbolic gesture," Whalen added. "Then you could selectively let the (trading) desk (at the New York Fed) sell MBS when there's a rally — trickle the stuff out, get 100 to 200 billion (dollars) off the books each quarter. The street is starving. These are all signals the Fed should be paying attention to."

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