Morgan Stanley: Our Conviction Has Only Grown Stronger That “Easy Is Over”.

From Morgan Stanley’s Matthew Hornbach, Global head of interest rates.

In our Global Strategy Mid-Year Outlook: The End of Easy, published in mid-May, my research colleagues and I suggested that multiple tailwinds from the last nine years were abating. While the outlook for macro economies remained promising, the outlook for risky assets was less so. A structural tightening in monetary policies, led by the total size of global central bank balance sheets peaking in mid-2018, stood at the heart of our concerns.

Now that we have entered the second half of the year, it makes sense to reassess this view. In short, our conviction has only grown stronger that easy is over. Monetary conditions continue to tighten across the globe, led by those in the US. What’s more, financial conditions are tightening as well. The Fed’s balance sheet normalization process not only continues, but accelerates this quarter and next. The caps that limit the amount the Fed’s balance sheet can shrink by increase from US$30bn in 2Q18 to US$40bn this quarter. Then, in the final quarter of the year, the caps increase to US$50bn where they max out.

As the caps go up, so too does US Treasury issuance. As the Treasury supply related to balance sheet normalization hits the market, it soaks up the cash that may have otherwise gone into riskier assets. It’s the once positive portfolio balance channel effect from the Quantitative Easing (QE) era – which supported risky assets all throughout that period – in reverse. QE has become QT (Quantitative Tightening) in the US. At the same time, the positive portfolio balance channel effect from the European Central Bank (ECB) is set to diminish further. On the ECB’s own guidance, QE will be done by year-end.

Sounds complicated? It may get more so next year.

Earlier this week, several of my colleagues and I came out with a view that the Fed’s balance sheet may not shrink as much as most people expect. We believe that the Fed will halt the normalization of its balance sheet by September 2019 and start growing it again in 2020 to ensure that the effective fed funds rate remains within the range the Fed targets.

We expect the Fed’s System Open Market Account (SOMA) portfolio to be just above US$3.8 trillion at the end of 2020. In contrast, primary dealers and market participants polled by the New York Fed place a 68% and 60% probability, respectively that the SOMA portfolio will be smaller than US$3.5 trillion at the end of 2020.

Importantly for markets, we expect the Fed to begin guiding investors toward the end of balance sheet normalization in the minutes of its December 2018 meeting. While December may seem ages away, the topic is sure to be increasingly on the minds of FOMC participants into year-end. This raises the risk that guidance may come earlier than we expect.

To be sure, we do not believe that a technical adjustment to the size of the balance sheet will alter FOMC participants’ views on appropriate rate policy. Balance sheet normalization will continue into next year even if the Fed ends the process earlier than it anticipated originally.