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Reaction to Fed balance sheet reduction is key

This week could be pivotal for US monetary policy. Financial markets are looking towards the FOMC meeting on Wednesday as an indicator for several key factors, however the Fed is likely to be the first central bank to start reducing the size of its balance sheet. Aside from the theoreticals, no one really knows how financial markets will react to the Fed’s balance sheet reduction. We look at the outlook for forex, equities and commodities.

Federal Reserve Building

Monetary policy is firmly on the agenda as we look ahead to the Fed meeting. However an unexpectedly hawkish shift in the rhetoric from the Bank of England has been the big mover of forex markets in the past few days. The MPC statement suggested that policy may need tightening faster than current expectations, whilst the withdrawal of stimulus would be needed in coming months to bring inflation back under control. Then, the most dovish member of the MPC, Gertjan Vlieghe, turned hawkish in suggesting “the moment was approaching”. Previously February 2018 was possible but now even November 2017 could be seen. Carney has a reputation of faking it, but this time the rhetoric does seem far more co-ordinated and traders are suddenly having to price for a rate hike much sooner than previously thought. As for the FOMC, it will be a very interesting meeting despite no rate hike being expected. Updates to economic forecasts will focus on inflation once more, but any adjustments to the dot plots could hint at a pause in tightening after the next hike (which could still be December). Furthermore, the likelihood is that the Fed will formally announce the start of “Quantitative Tightening” or balance sheet run down (even arch dove Lael Brainard expects it to be this week). However, given the weakness of the dollar to QE, the impact on Treasury yields and the dollar in the coming months could be more pronounced than many are expecting, or pricing.


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