New Fed Debate, Yellen Up Next

Members of the Federal Reserve have begun speaking about when and how to trim QE holdings for the first time. The US dollar was weak leading into New York trading. The kiwi led the way while the pound lagged. Yellen is speaking later but it's not likely to be market moving. The Premium Insights issued a new JPY trade.

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Until now the debate at the Fed had largely been about when to hike interest rates and how much, while questions about the balance sheet were unaddressed. Three separate Fed members broached the subject this week in what was surely a coordinated communication shift.

For some background, the Fed purchased a whopping $4.5 trillion in Treasuries and mortgage-backed securities in QE programs in the aftermath of the crisis. That value remains steady because when bonds mature, they buy other bonds. The general FOMC exit plan to bring its balance sheet back to normal levels is to stop reinvesting maturing bonds and let the holdings slowly run off. Another option would be to sell holdings.

The central question revolves over the start of unwinding. The Fed has long indicated it would raise interest rates first but has never been specific about how high rates would need to go before halting reinvestment. On Thursday, Philly Fed President Harker said the FOMC should consider ending bond buys when the Fed funds rate hits 1%. That would be after 2-3 more hikes.

Earlier this week, Rosengren said the Fed should consider trimming its balance sheet and on Thursday Bullard suggested the Fed could stop reinvestment after one hike. Other debates include what portion of Treasuries and MBS to hold and the duration of the portfolio.

The debate muddies the Fed picture for 2017. What's more hawkish? Three hikes or two hikes and stopping reinvestment? That's not an easy question to answer but it's increasingly clear to us that the bond market is in charge at the moment. A strong Treasury auction Wednesday was followed by one that was very close to expectations Thursday. Dollar swings followed both.

Other notes from Thursday's trade

-US economic data remains strong with initial jobless claims down to 247K versus 255K expected.

-But the dollar is an issue. Lockhart said the dollar was an issue for exporters and the export/import price indexes both missed estimates in a way that suggested a larger USD factor.

-The event to watch in Asia-Pacific hours is a scheduled speech from Yellen at 0000 GMT. Unfortunately, it could be a dud. The event is a town hall with teachers so expect talk about financial education. But she will take questions so there may be some notable headlines.