Fed Minutes

The minutes from the April FOMC meeting were released on Wednesday providing more insight into the committee’s discussion of future monetary policy, specifically the portfolio of MBS and Treasuries scheduled to reach its peak at the end of June.

There weren’t a lot of major surprises in the minutes. The Fed is telegraphing a slow process that begins with letting the maturing bonds pay off without reinvesting the proceeds, followed by actual selling of securities, either through the repo market or outright sales. Ending reinvestments would be considered tighter policy by itself relative to maintaining the balance sheet at the current $2.6 trillion target, but such a bloated Fed balance sheet is not sustainable.

Most members seem to favor a very gradual process of selling, but some members are calling for all the longer-term bonds to be sold in 1-2 years from the beginning of the tightening campaign. I don’t think the rapid selling plan has a chance of happening under this Fed.

No decision was made on the normalization plan. One of the more specific plans floating around includes a set schedule of asset sales that would act as a passive tool for normalization of longer term interest rates, while the Fed Funds target rate would be used as more of an active tinkering tool. I like the idea of a passive unwind absent all tinkering. My feeling is that the more active the Fed gets, the more they interfere with the natural pricing of risk. I enjoy dreaming.

Inflation Expectations

Inflation expectations are down from their most recent highs, mostly due to the recent selloff in commodities, and lower growth estimates that have caused nominal Treasurys to rally and yields to fall.

We are still above the ten-year average for inflation expectations, but TIPS have underperformed nominal Treasurys recently, as expectations have ticked down.

Inflation expectations have tracked commodities very closely since the effective announcement of QE2 by Bernanke in Aug 2010.

The bond rally in May has taken yields to the lowest end of most recent range. Turmoil abroad is probably to blame for the last 20 basis points in yield movement as it has accompanied a dollar rally. Expectations of more QE have tended to hurt the dollar, so I don’t think that is to blame. But anything is possible.

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst