Understanding the Recent Fed Action

This past December, the Federal Reserve stated that a reduction in its balance sheet would not begin until the “normalization of the level of federal funds rate is well under way.” In June, the Fed provided details of its plan to reduce their balance sheet which ballooned to $4.5 trillion after the 2008 financial crisis in order to stabilize the economy and later stimulate growth.  
On September 20, a unanimous Fed announced that a reduction of its balance sheet would begin in October, starting with a cap of $10 billion per month in securities. This reduction will be carried out by allowing securities to mature and not reinvesting the proceeds. The Fed plans to increase the cap quarterly. During the fourth quarter of 2017, $6 billion of Treasury securities and $4 billion in mortgage-backed securities will be targeted for runoff each month. The following quarter, the maximum monthly reduction will be $12 billion in Treasuries and $8 billion in mortgages. The reductions will increase up to a maximum of $30 billion in Treasuries and $20 billion in mortgages per month.  
The general expectations are for the balance sheet reductions to be carried out over roughly three years. The Fed stated, “in our estimation, the actual amount of runoff will be less than implied by the cap sizes; we expect the balance sheet to normalize at about $3 trillion in approximately three years.” The reaction to the announcement was fairly benign in the Treasury and mortgage markets. The subsequent sell-off in rates was driven by the tax reform announcement and solid economic data at the end of the quarter.   
Another lever the Fed can use to influence interest rates is the federal funds rate, which was raised twice this year—once in March and again in June. After four rate hikes, beginning in December 2015, the federal funds rate stands at a range of 1.00% - 1.25%. The September FOMC meetings concluded with no change to rates. However, the hawkish tone delivered by the Fed through its “dot plots” showed continued support for a third rate hike in 2017 by 12 of the 16 FOMC members. This sent the implied probability of another rate hike this year up to 70%, from the low of 30% at the end of August.
The dot plots indicate three additional rate hikes in 2018, which implies a 2.125% federal funds rate at the end of next year. In 2019, the expectations are for two more rate hikes as the implied rate was lowered from 3.0% to 2.75%. After this year, very little is priced into the market. There have been several instances in this cycle where the Fed successfully guided the markets toward hikes with limited disruption. Future decisions rely on data and market conditions at the time, which remains our focus. 
The opinions contained herein are those of Longfellow Investment Management Co. LLC (LIM) at time of publication and may vary as market conditions change. They are based on information obtained by LIM from sources deemed to be accurate and reliable. However, accuracy is not guaranteed. It is in the sole discretion of the reader whether to rely upon the opinions contained herein. The information provided does not constitute investment advice, is not a recommendation, offer or solicitation to buy or sell any securities, or to adopt any investment strategy and should not be relied upon as such. It does not take into account an individual investor’s particular investment objectives, strategies, tax status or investment horizon. There is no guarantee that any forecasts contained herein will come to pass.  Past performance is not an indication of future results. Investment involves the possible loss of principal.