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Jan. 29, 2020, 9:20 a.m. EST

Fed starts some tricky communications with financial markets

Fed may hike IOER rate, widely seen as a technical adjustment. But how will the market take it?

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By Greg Robb, MarketWatch


Reuters
Fed Chairman Jerome Powell doesn’t think the central bank’s move to expand its balance sheet is “QE” or has been a key factor in driving risk assets higher.

The Federal Reserve seems on course to disappoint financial markets at some point this year, but maybe not Wednesday.

Starting early in 2019, the Fed has consistently moved in a market-friendly direction. The central bank cut rates its benchmark interest rate three time since July and started expanding its balance sheet in October at a $60 billion per-month pace of Treasury bill purchases. It has also been lending billion of dollars into the short-term money market.

Stocks rallied, credit spreads tightened further and the dollar fell, all easing financial conditions.

But with valuations higher, sentiment positive and fundamentals still soft, Fed policy is now carrying a heavy load, said Andrew Sheets, chief cross-asset strategist at Morgan Stanley.

Read: Chicago Fed President is heavily influencing the Bank of England’s monetary policy

Morgan Stanley experts think the Fed wants to end its $60 billion-a-month purchases of Treasury bills at the end of April and let its balance sheet plateau. In its place, they expect a smaller $15 billion-a-month of purchases across the Treasury curve, Sheets said. Mark Cabana of Bank of America Global Research thinks the Treasury-bill purchases will continue through June but might be tapered. He thinks the lending to the repo market will end in May.

Read: Steps that might make the Fed’s balance sheet expansion less frothy

Such policy shifts could rattle the stock market, said Diane Swonk, chief economist at Grant Thornton.

“Many financial market participants believe that the liquidity provided by the Fed has helped to boost stock prices above and beyond what rate cuts along could do; any moves to stop that growth could show up as a loss in momentum for stock prices,” Swonk said.

Fed Chairman Jerome Powell has stressed that the expansion of the balance sheet isn’t a form of quantitative easing, meant to stimulate the economy by driving down long-term interest rates. But a lot of commentators do. And even Dallas Fed President Robert Kaplan thinks the purchases are having “QE-like effects.”

Since Tuesday, Fed officials have been deliberating about the balance sheet, money-market lending and the appropriate level of short-term interest rates.

The Fed will release a statement at 2 p.m. Eastern. Powell will follow with a press conference at 2:30 p.m..

“Clearer communication is needed to allay concerns among investors that an end to building reserves will pull the rug out from under risk assets. The Fed aims to enter the spring with ample reserves and does not see its purchases of T-bills as a key factor in driving risk assets higher,” said Ellen Zentner, chief economist at Morgan Stanley.

Economists don’t anticipate any change in balance-sheet policy at this week’s policy meeting. But there could be one small step that could test the Fed and market’s relationship.

The Fed is widely expected to make a technical hike to the interest it pays on excess reserves, raising this IOER rate 5 basis points to 1.6%. The Fed’s lending has moved the rate lower. Economists will be watching to see if there is any market reaction.

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