Fed balance sheet:

• As the U.S. Federal Reserve pivots away from rate hikes, questions remain about the path forward for the Fed’s balance sheet.
• This issue took on a heightened relevance at the end of 2018. Markets were spooked at that time by Fed Chair Powell’s comment that the process of shrinking the central bank’s balance sheet was on “autopilot” – as opposed to being sensitive to economic and financial market developments.
• However, we suspect some of this market concern was misplaced:
  • The appropriate lever for responding to sudden shifts in economic and market conditions is the fed funds rate, not the Fed’s balance sheet. To this end, the Fed has stopped tightening since conditions turned in late 2018.
  • The fact that the decline in the Fed’s balance sheet has been a highly mechanical affair – with flows telegraphed years in advance – actually argues that the market couldn’t possibly have been suddenly hurt by anything having to do with balance sheet transactions.
  • Primary dealers indicate that the Fed’s transactions have not in actual fact wreaked havoc on the Treasuries market.
  • If the increase in interest rates over the past few years was primarily the result of a shrinking Federal Reserve balance sheet, the term premium should be actively widening, reversing the process that took place during quantitative easing operations. However, in practice, the term premium remains very low.
• When the Fed engages in quantitative tightening of the sort undertaken over the past few years, this doesn’t so much involve actively selling bonds. It involves waiting for bonds to naturally mature, and failing to reinvest the proceeds. The financial windfall is then erased from the balance sheet, in much the same way as the introduction of quantitative easing conjured money out of thin air. Only central banks are allowed to do this.
• The Fed’s balance sheet matters in the sense that it provides a means of delivering and withdrawing stimulus. In theory, printing money and expanding the balance sheet stimulates the economy via three channels: a larger money supply, lower bond yields and higher risk appetite. In practice, the first of these never really took hold over the past decade as banks sat on excess reserves, leaving the remaining two to do yeoman’s work.
• Now, as the process occurs in reverse, the question is the extent to which bond yields must rise and risk appetite must fall. To the extent that the bond sales have long been telegraphed and the bond market is forward-looking, it seems unlikely that yields have to rise much further on their behalf. And we are equally skeptical that risk appetite must be damaged going forward. Keep in mind that the psychological boost that came from the initial application of quantitative easing was designed to restore confidence from rock-bottom levels to more normal levels. To the extent that confidence is now at a normal level, it makes little sense that confidence must collapse as those special measures vanish.
• The Fed is now arguably at least half way through its process of balance sheet reduction. This might seem a premature claim, given that the U.S. monetary base stood at just $800 billion before the global financial crisis, it peaked at a whopping $4.5 trillion in 2015, and has since merely fallen back to $4.0 trillion.
• But as a result of a growing economy, declining bank leverage and a declining velocity of money, economies need a far bigger monetary base than before just to sustain normal economic conditions. Forecasters peg the end point for the Fed’s balance sheet at somewhere in the $3.5 trillion range.
• At the current clip of $50 billion in net bond maturities per month, the Fed could well be done its remaining bond sales in under a year. More realistically, given a likely desire to smoothly decelerate, the process could take slightly longer.
• The balance sheet is again in play: expectations are mounting that the Fed could announce its final target and trajectory within the next quarter or two. It is hard to imagine the Fed remaining mum when the era of balance sheet reduction is evidently approaching its natural conclusion.

U.S.-China:

• Cautiously positive news has emerged on the U.S.-China file.
• After meetings between President Trump and China’s Vice Premier last week, Trump tweeted over the weekend that the March 1st negotiating deadline between the two countries would be extended. This means that the 10% tariffs on $200B in Chinese goods will not automatically jump to a 25% rate.
• However, existing tariffs between the two countries remain in place, meaning that our “negative” protectionism scenario remains the base case. Moreover, this constitutes far from a best case scenario. That would involve a deal being struck on time.
• The shifting deadline suggests the U.S. wants a deal, and potentially believes one is fairly close at hand. There is a good chance that U.S. demands have softened somewhat in this pursuit, perhaps motivated by jittery risk assets over the past several months.
• In terms of the ultimate contours of any deal:
  • Not a great deal of progress had been made as of last week.
  • China continues to pledge to purchase more soybeans and to reduce its auto tariffs, though these are fairly small gestures. More purchases of U.S. tech products could also be in the offing, though this is complicated by the fact that the U.S. is growing skittish about exporting too much high-grade technology to China.
  • On the other hand, China is seeking to reduce U.S. pressure on its national champions.
  • The big question is whether any changes occur to Chinese industrial policy: does China provide additional market access to foreign firms and/or change its intellectual property practices?
• From here, expectations are that President Trump and President Xi will meet in Florida sometime in late March or April to finalize a deal.
• We continue to believe that significant structural frictions will remain between the two countries, even after any superficial deal.

Auto tariffs:

• On February 17th, the U.S. Commerce Department submitted its Section 232 (National Security) investigation on auto imports to the White House. This investigation was designed to create an opportunity for the U.S. to levy tariffs on imported European and Japanese motor vehicles.
• So far, the results of the investigation have not yet been made public. As such, we don’t know whether the investigation recommends tariffs or not. The White House has up to 90 days to act on the recommendations.
• There are two quite different interpretation possible:
  • Perhaps the Commerce Department felt that auto tariffs did not obviously improve national security, but the White House is keeping that information secret for now so as to maximize pressure on Europe and Japan.
  • Alternately, perhaps the Commerce Department recommended auto tariffs, but the U.S. wishes to first solve the China trade dispute before knocking over another hornet’s nest. In this scenario, auto tariff threats might intensify in April after any Chinese deal.
• Europe and Japan are natural targets for U.S. trade policy, as both run substantial trade surpluses versus the U.S. In fact, Europe already agreed to trade talks last summer.
• Auto trade flows are large enough that any auto tariffs could significantly impede global growth. However, we also recognize that a large fraction of the European and Japanese vehicles sold into the North American market are already made in the U.S., Mexico or Canada.

Other items:

• Brexit: Theresa May will give a speech on February 26th asking parliament for more time to renegotiate the Irish backstop with the EU. Conversely, a vote will be held on February 27th – with a rising chance of success – to take the Brexit decision partially out of the hands of the Prime Minister by requiring a formal extension of Article 50 if a deal is not struck with Europe by March 13th. Recall that the official Brexit deadline of March 29th is rapidly approaching. The declining risk of an uncoordinated Brexit, in turn, is prompting some of the Conservative Party members at the harder end of the Brexit spectrum to reconsider May’s original pitch, increasing the chance that it could succeed after some tweaks. In a nutshell, the odds of Brexit negotiations drifting beyond March 29th are growing, and the odds of an uncoordinated hard Brexit are falling. The latter, at least, is good news.
• Government shutdown: As widely reported, a second U.S. government shutdown in quick succession was avoided on February 15th. Congress and the White House reached an agreement to fund the U.S. federal government through the end of September. The budget furnished only $1.4B for border fencing – less than the $5.7B desired by Trump. In turn, the White House has declared a state of emergency, providing access via other means to the funding Trump desires for the border. Many U.S. states have now sued the president over his usage of the emergency laws, leaving an uncertain conclusion. The silver lining is that the shutdown will not re-emerge for another seven months at the earliest.
• Debt ceiling: On the other hand, the U.S. debt ceiling re-emerges on March 1st. But a sovereign default is still improbable given ample room to draw down on cash balances and engage other avoidance tactics. Realistically, the debt ceiling won’t become a pressing political issue for several months.