FOMC Surprises Markets by Expanding Balance Sheet

• FOMC confirms that federal funds rate of 0 to 0.25% will be applicable for an extended period....
• .....and that it will expand its balance sheet amongst other by purchasing Treasury securities....
• ......Treasuries show their bigger rally in many years , dollar is hit and equities gain modestly...
• .....Governor Lacker joins majority as he always favoured the purchase of Treasury securities

Rock bottom rates for longer...

The FOMC decided as expected to keep its target range for the fed funds rate at 0 to 0.25%. It added that "economic conditions are likely to warrant exceptionally low levels of the federal funds for an extended period of time", while before the statement said "for some time". So, this should be considered as a first loosening of policy.

Economic outlook unchanged, but no longer downside risks

The paragraph on the economy was largely similar as in January. The FOMC said the economy continued to contract. It described the (ugly) situation in the various sectors of the economy. There are two noticeable changes as compared to the January statement. Firstly, the Fed doesn't reiterate that "conditions in financial markets have improved". Does that mean the Fed thinks they have deteriorated again, or wasn't that phrase appropriate when it decided at the same time to expand its balance sheet? Secondly, the "Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth". Two changes here compared to January. The Fed no longer says the recovery will begin later this year. However, on the other hand, its assessment is not accompanied anymore by the warning that downside risks to the outlook are significant.

On inflation, the wording of the statement is broadly unchanged. The FOMC expect inflation to remain subdued and retains its view that the risk is that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term." Fed expands its balance sheet The Federal Reserve reiterated that it will employ all available tools to promote growth and preserve price stability. However, the biggest surprise was the announcement it will expand a number of existing programs of purchases of assts.

More specifically, "To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion." This was a surprise as the past purchases had not yet exhausted the allowed maximum amounts.

Fed starts buying Treasury securities

In recent speeches and in the previous FOMC statement, the Fed and Fed governors had downplayed the imminent start of a program to buy Treasuries. Such purchases were seen as an ultimate weapon, if the credit easing policy of buying private sector assets would fall short of the expected results. Some governors suggested that the evaluation of these actions would take place late in spring.

The Fed clearly chose for a shock therapy by announcing now the immediate start of such a program.

So the Fed announced that it will purchase up to $300B of longer-term Treasury securities over the next six months. The NY Fed open market desk already gave some details about the purchases that are important. The purchases will be concentrated in the 2-to-10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS curves. The purchases will be conducted with the primary dealers and via competitive auctions. They will take place two to three times a week and should start next week. Further details will be made available next week.

Very strong market reactions

The decision was a big, big surprise and most analysts, including us, and market participants were taken completely off guard. As a result frenetic market activity took place after the decision and price movements were major. The Treasury market had an incredible strong rally, maybe the strongest in decades, as yields really collapsed. At the end of trading, yields were down 22 basis points at the 2- year, 40.6 at the 5-year, 47.3 at the 10-year and 29.3 at the 30-year. The underperformance of the 30-year is probably due to the details made available by the Fed open desk (see higher). The 2-year underperformed too, but this underperformance is in our eyes even a strong performance, probably due to the fact that also two year Notes may fall under the purchase program and because of the "promise" of the Fed to keep short term rates exceptional low for an extended period of time.

In the currency markets, the dollar got badly hit and lost ground across the board. EUR/USD made a technically important move above the key level of 1.3330. Equities rallied too, but closed off the highs with good, but no exceptional gains. The S&P didn't manage to take out the key 804 level. However, we should not forget that equities were already sharply up in the previous 6 sessions. Piet Lammens, KBC Brussels

March 19 FOMC statement

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.

Disclaimer: This non-exhaustive information is based on short-term forecasts for expected developments on the financial markets. KBC Bank cannot guarantee that these forecasts will materialize and cannot be held liable in any way for direct or consequential loss arising from any use of this document or its content. The document is not intended as personalized investment advice and does not constitute a recommendation to buy, sell or hold investments described herein. Although information has been obtained from and is based upon sources KBC believes to be reliable, KBC does not guarantee the accuracy of this information, which may be incomplete or condensed. All opinions and estimates constitute a KBC judgment as of the data of the report and are subject to change without notice.