The Fed Will "Massively Disappoint" Markets Tomorrow: Here's Why

With activist central banks once again backstopping markets during the recent bear market scare, which prompted Fed Chair Powell to turn from a hawk to a "patient" dove in just a few weeks, markets, traders and economists have turned their attention to the biggest driver of risk, namely the Fed's balance sheet, which after expanding for the better part of the past decade has been shrinking at an "autopilot" pace of roughly $36 billion per month ever since it hit its "peak shrinkage" in Q4 of 2018...

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... and prompted a barrage of media coverage in recent days including the following:

It is therefore hardly a coincidence that just over a week ago, JPMorgan's head quant Marko Kolanovic said that there is one chart that "traders tape to their screens, blogs and email chains", namely the complete QT calendar consisting of past and projected Fed Balance sheet QT weekly periods, such as the one shown below courtesy of Nomura's George Goncalves. The reason why this schedule matters, is because - whether due to a self-fulfilling prophecy or some other liquidity soaking market dynamic - on days when the Fed's balance sheet shrinks whether due to Treasury or MBS maturity, think of it as a reverse POMO, risk assets are hit.

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Adding fuel to the dovish fire was a Friday article in the WSJ which said the Fed is considering a quicker end to its balance sheet runoff which has caused so much market anxiety and volatility. According to the WSJ, Fed officials "are close to deciding they will maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight." The article also added that "officials are still resolving details of their strategy and how to communicate it to the public" however, "with interest rate increases on hold, for now, planning for the bond portfolio could take center stage."

So with so much of the market attention once again falling on the Fed's balance sheet especially in the aftermath Powell's recent dovish U-turn, there is a palpable expectation that tomorrow the Fed will announce it is nearing a decision on when to end the reduction of balance-sheet holdings, essentially a pause in the quantitative tightening cycle.

However, as Bloomberg's Vincent Cignarella warns, the difference in what the Fed says and what the markets hear may once again be on display during Wednesday's press conference. Indeed, the Fed has previously said the fed funds rate is the central bank’s primary monetary policy tool, not the balance sheet. As such, if the Fed holds to this mantra, investors looking for comments curtailing the balance sheet runoff may be "massively disappointed" according to the Bloomberg macro commentator.

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