How To Take Advantage Of Fed’s Unwinding

September 18, 2017

| Fullerton Markets

How To Take Advantage Of Fed’s Unwinding

Fed’s balance sheet unwinding could drive equities lower, sell USD/JPY?

Shrinking the balance sheet is likely to reverse the portfolio rebalancing effects of QE, which may spur demand for safe haven assets

Dollar stayed firm near the seven-week high versus yen on Monday. It is supported by recent rise in US Treasury yields. Data last week showed a pick up in US consumer prices. It raised the expectation of another Fed rate hike in December. But most importantly, investors are paying close attention to FOMC meeting this week. They are expected to offer details on its trillions balance sheet unwinding. Fed is likely to announce a plan to start shrinking its balance sheet at the meeting, but they are widely expected to keep interest rates unchanged.

Data last week showed the strongest increase in US CPI in seven months. China and Euro zone inflation readings have also improved in this period, suggesting global inflation growth may have improved again.

The yield on two-year Treasury notes was up 1.6 basis points at 1.384%. It touched 1.388% for a second time earlier Friday, which was its highest since 26^th July. Interest rates futures implied traders saw as high as 58% chance of a December rate increase, compared with 31% a week earlier, CME Group's FedWatch tool showed.

Focus remains on balance sheet unwinding details this week. Fed stopped its buying in 2014, but intentionally refrained from paring its bloated balance sheet until they are sure the economy is good and ready. The moment is approaching now, with most policy makers expecting the process to begin later this year.

Nobody really knows the impact of balance sheet unwinding on dollar at this moment. However, one thing could be expected, stocks and other risky assets could come under selling pressure amid Fed’s asset unwinding. After global central banks embarked on quantitative easing, investors were forced out of bonds into equities and high-yielding debts. Economists at the board of governors of Fed had estimated quantitative easing had depressed the term premium by a 100 basis points; which means market had priced in less risk. Unwinding the balance sheet could reverse the effect and bring about uncertainties in the market.

Against that backdrop, US stocks are trading at or near all-time highs. Shrinking the balance sheet is likely to reverse the portfolio rebalancing effects of quantitative easing, which had lowered the market supply and increased the prices of risky assets. If that happens, lower US Treasury yields could be seen, as well as a higher yen.

Our Picks

GBP/USD – Slightly bearish.

Pound rallied after BOE, momentum seems to be exhausting now. This pair failed to break 1.36, it may retrace towards 1.3530.