Deutsche Bank: A Bloated Fed Balance Sheet Threatens to Speed Up Rate Hikes

A Yellen Conundrum looming?

Will a Fed Rate Hike Be Positive for Global Stocks?

The Federal Reserve has chosen to start the process of raising interest rates before shrinking its balance sheet.

According to economists at Deutsche Bank, that decision may force Fed Chair Janet Yellen to raise rates faster than the market expects in order to damp down the U.S. economy's momentum. 

The hawkish commentary in the Federal Reserve's October statement, followed by a stellar non-farm payrolls report that supported this shift in tone, fostered a rise in interest rates across the yield curve, observes Deutsche's Chief Economist Peter Hooper.


As such, the market has once again recalibrated the expected pace of interest rate rises following liftoff (remember one and done?), while the probability of a first hike by year-end spiked.

"The pace of rate hikes will be influenced by a number of economic and financial factors, including, importantly, the reaction of long-term rates," the economist wrote.

Hooper expects a combination of the market's upward revision to the pace of Fed hikes, net sales of U.S. Treasuries by foreign central banks, and the tapering off of the Fed's principal re-investments from previous bond purchases will propel the 10-year Treasury yield to as high as 3.5 percent by the end of 2016 as U.S. government debt is sold off.

But, says Deutsche, that dynamic is set to change in 2017, as the Fed's massive Treasury holdings will cap the rise in longer-term yields relative to short-term rates. That is, Janet Yellen is poised to inherit former Fed Chair Alan Greenspan's conundrum, in which the supposed failure of long-term rates to rise by as much as the central bank's policy rate entails that monetary policymakers aren't able to tamp down on growth as much as they desire:

Deutsche Bank

Deutsche Bank's economists cite a remark made by New York Fed President William Dudley in an April speech to support their case.

"If financial market conditions do not tighten much in response to higher short-term interest rates, we might have to move more quickly to achieve the appropriate restraint on financial market conditions," Dudley said.

The upshot: the central bank's so-called glide path higher could be steeper than investors currently anticipate as more hikes are needed to tighten financial conditions in the face of  persistently low yields at the longer end of the curve.

Hooper believes that Yellen & Co. would prefer an outcome of this nature, despite the imbalances that developed and culminated in the U.S. housing crisis in part due to the aforementioned conundrum.

"While the Fed wants to tighten financial conditions sufficiently to avoid an overheating economy, they also would like to be able to maneuver the fed funds rate as far away from the zero lower bound as possible," argued Hooper. "Doing so will provide them with ammunition to combat future downturns using traditional monetary policy tools, and allow them to cleanly exit from the extraordinary policies that have dominated the post-crisis policy landscape."

Conversely, the initiation of a hiking cycle could create a tightening of financial conditions and, in turn, economic activity, faster than during previous instances.

Some economists and strategists have suggested that the Fed's new regime, coupled with regulatory changes, could shorten the lag time for the transmission of monetary policy. After liftoff, more bank deposits are expected to flow into money-market funds thanks to a new instrument monetary policymakers are employing to execute the rise in their policy rate.

But new regulations also mandate that banks hang on to more high-quality liquid assets - so they'll need to make sure too many deposits don't head out the door. One way to do that is to raise the interest rate paid on these deposits. As this increases lenders' funding costs, the charge could then be borne by consumers in the form of higher borrowing costs, which would tend to prompt a decrease in the demand for credit.

If that proves to be the case, then Yellen and her colleagues at the Federal Reserve will have a new concern: whether inflation can trend up to 2 percent even after the central bank has begun tapping the U.S. economy's brakes.

Before it's here, it's on the Bloomberg Terminal.