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Daily Pivots: (S1) 0.8520; (P) 0.8536; (R1) 0.8549; More...

EUR/GBP dips mildly today but stays above 0.8483 temporary low. Intraday bias remains neutral at this point. As noted before, decline from 0.8786 could be developing into the third leg of the whole corrective pattern from 0.9304. And hence, deeper fall is expected ahead. On the downside, break of 0.8483 will turn bias to the downside for 0.8402 support first. Decisive break there should confirm our bearish view and target 0.8303 and below. As fall from 0.9304 is viewed as a corrective move, we'd expect strong support at 0.8116/20 cluster support to contain downside and bring rebound. On the upside, above 0.8604 minor resistance will delay the bearish case. That is, one more recovery will be seen to complete a five wave triangle pattern fro 0.8303 before completion.

In the bigger picture, price actions from 0.9304 are viewed as a medium term corrective pattern. Such decline is likely ready to resume and should make a new low below 0.8303. At this point, we'd expect strong support from 0.8116 cluster support (50% retracement of 0.6935 to 0.9304 at 0.8120) to contain downside. Rise from 0.6935 (2015 low) will resume at a later stage to 0.9799 (2008 high). However, sustained break of 0.8116 could bring deeper decline to next key support level at 0.7564 before the correction completes.

Some selling pressure is seen in Euro in Asian session as the common currency is dipping through Monday's low against Yen and Sterling. French election in April and May is the main focus for the common currency for now. But it should be noted that instead of political uncertainties, Euro's current selloff is more due to adjustments on ECB expectations. That is, there is little chance for ECB to raise interest rate soon in spite of the "hawkish twist" back in March. There are talks that Euro could be given a lift after French election but that would likely be just temporary. The situation of the British Pound is indeed quite different as Sterling has survived news of Brexit and stayed firm. BoE outlook is the main support for the Pound as Kristin Forbes voted for a rate hike back in March. And that was accompanied by stronger than expected February headline inflation reading. UK CPI release today will be importantly to decide whether Sterling can hold on to its resilience.

ECB Draghi: 2016 was a good year

ECB President Mario Draghi said in the central bank's annual report that 2016 "ended with the economy on its firmest footing since the crisis," even though the year began "shrouded in economic uncertainty". The report noted that the scaling back of asset purchase from EUR 80b per month to EUR 60b "reflected the success of our actions earlier in the year: growing confidence in the euro area economy and disappearing deflation risks". However, overall, the Eurozone economy's recovery is still dependent on massive support from the central bank. And the report also reiterated the calls on governments' effort on fiscal reforms.

Fed Yellen: Policy stance closer to neutral

Dollar fails to extend last week's rally while stocks and yields also lost some momentum. Fed chair Janet Yellen said yesterday that the central bank has shifted its focus the economy is closing to the targets of inflation and employment. She said that before, Fed had to "press down on the gas pedal trying to give the economy all of the oomph that we possibly could." But now, Fed is trying to "give it some gas, but not so much that we're pushing down hard on the accelerator." And, the "appropriate stance of policy" is now closer to "neutral". But she also emphasized not be to "ahead" nor "behind" the curve. Or, Fed would be in a position to "have to raise rates rapidly, which could conceivably cause a recession".

Australia business conditions improved, confidence dropped

Australia NAB business confidence rose 5 pts to 14 in March, hitting the highest level since the global financial crisis. But business confidence dropped 1 pt to 6. NAB noted that "the bounce in business conditions this month came as a bit of a surprise, especially the big improvement in Queensland in light of the likely disruptions from Cyclone Debbie in late March." And, "one possibility is that 'Debbie' is having the unexpected effect of overstating conditions in March given that the cyclone coincided with a lower response rate from firms in Northern Queensland.". But overall, "conditions have improved almost across the board to levels that suggest a strong economy in the near term."

On the data front...

UK BRC retail sales monitor dropped -1.0% yoy in March. Australia NAB business confidence dropped to 6 in March. UK inflation data will be a main focus for today as CPI, RPI and PPI will be released. Germany will release ZEW economic sentiment while Eurozone will release industrial production. No important economic release is scheduled for US session.

EUR/GBP Daily Outlook

Daily Pivots: (S1) 0.8520; (P) 0.8536; (R1) 0.8549; More...

EUR/GBP dips mildly today but stays above 0.8483 temporary low. Intraday bias remains neutral at this point. As noted before, decline from 0.8786 could be developing into the third leg of the whole corrective pattern from 0.9304. And hence, deeper fall is expected ahead. On the downside, break of 0.8483 will turn bias to the downside for 0.8402 support first. Decisive break there should confirm our bearish view and target 0.8303 and below. As fall from 0.9304 is viewed as a corrective move, we'd expect strong support at 0.8116/20 cluster support to contain downside and bring rebound. On the upside, above 0.8604 minor resistance will delay the bearish case. That is, one more recovery will be seen to complete a five wave triangle pattern fro 0.8303 before completion.

In the bigger picture, price actions from 0.9304 are viewed as a medium term corrective pattern. Such decline is likely ready to resume and should make a new low below 0.8303. At this point, we'd expect strong support from 0.8116 cluster support (50% retracement of 0.6935 to 0.9304 at 0.8120) to contain downside. Rise from 0.6935 (2015 low) will resume at a later stage to 0.9799 (2008 high). However, sustained break of 0.8116 could bring deeper decline to next key support level at 0.7564 before the correction completes.

Economic Indicators Update

EURUSD

The EURUSD was indecisive yesterday. The bias is neutral in nearest term. Overall price is still in a bearish phase since the false break above 1.0873 key resistance two weeks ago but as you can see on my H4 chart below price respecting a trend line support which is a good place to buy with a tight stop loss as a clear break below the trend line support and 1.0570 area would expose 1.0500 region. Immediate resistance is seen around 1.0620. A clear break above that area could trigger further bullish pressure testing 1.0700 region. On the downside, a clear break and daily close below 1.0500 would expose 1.0350 area. Overall I remain neutral.

GBPUSD

The GBPUSD failed to continue its bearish momentum yesterday topped at 1.2428. The bias is neutral in nearest term. The bearish outlook after broke below the triangle (see my H1 chart below) remains valid with 1.2450 as key resistance (H1 EMA 200). A clear break above that area would nullify the bearish scenario testing 1.2500 region. Immediate support is seen around 1.2375. A clear break below that area would expose 1.2300 region. Overall I remain neutral.

USDJPY

The USDJPY attempted to push higher yesterday topped at 111.57 but closed lower back below 111.30 key resistance and hit 110.62 earlier today in Asian session. The bias is neutral in nearest term probably with a little bearish bias testing 110.10 key support which is a good place to buy with a tight stop loss as a clear break and daily close below that area could trigger further bearish pressure testing 108.50 region. On the upside, 111.30 remains a key resistance. Any sustained movement above that level could trigger further bullish pressure testing 112.00 or higher.

USDCHF

The USDCHF was indecisive yesterday. The bias is neutral in nearest term but overall price is still in a bullish phase with 1.0020 – 1.0060 as key support area targeting 1.0170 area. A clear break and daily close above that area would expose 1.0250 or higher. On the downside, a clear break and daily close back below 1.0020 would be a threat to the bullish phase testing 0.9970 region. Overall I remain neutral.

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EUR/USD

The pair traded within narrow range during the most of European session and holding above new marginally lower one-month low at 1.0570. Lack of data on Monday kept the single currency against dollar in narrow consolidation after Friday's strong fall when the pair ended trading down 0.43%.Strong bearish sentiment, established in last three days of the past week and boosted by fresh geopolitical tensions in the Middle East after US army attacked the airbase of Syrian army, failed to extend bear-leg from 1.0689, Apr 05 lower top, despite long bearish candle of Friday that was expected to produce stronger downside pressure. In addition, the greenback paused fresh rally that was sparked after Friday's attack on Syria and mixed jobs data last Friday.The euro briefly probed below key near-term support at 1.0584, base of daily Ichimoku cloud, but was unable to hold losses below cloud and generate stronger bearish signal.Daily cloud base now acts as solid support for recovery that commenced in early American session, signalled by reversal of daily chart slow stochastic after being deeply oversold.However, corrective attempts during mid / late American session remained capped by daily cloud top at 1.0611, as investors were awaiting speech from Fed Chair Janet Yellen to get more information about US policy, the timing of Fed's next interest rates hike and to possibly learn about Fed's plan to start shrinking its massive $4.5 trillion balance sheet.Technical studies are in negative mode on daily chart and maintain downside risk, which would be accelerated on firm break below daily Ichimoku cloud.

Resistance: 1.0611; 1.0622; 1.0668; 1.0700
Support: 1.0584; 1.0570; 1.0525; 1.0494

USD/JPY

The USDJPY pair extended bounce from temporary base at 110.00 zone, after last Friday's repeated downside rejection and subsequent bounce that managed to close briefly above 111.00 handle and sideline immediate downside risk. Recovery extension above daily Tenkan-sen line at 111.16 was seen as another supportive factor for stronger recovery, on daily close above the indicator which would then turn to solid support for further recovery. Probes above Tenkan-sen pivot remained capped by falling 20SMA at 111.60 in late Asian trading on Monday and the pair remained at the back foot during European and American session. Formation of double-bottom at 110.00 that is bullish signal, was expected to support scenario of stronger correction after multiple downside rejections at 110.00 zone.So far, the pair was unable to sustain break above Tenkan-sen barrier, diminishing hopes of stronger recovery that requires confirmation on firm break above daily Tenkan-sen and weekly Ichimoku cloud top at 111.36.While these pivotal barriers stay intact, prospects for extended correction will be limited.In such scenario, the pair may hold in extended consolidation between 110 base and weekly cloud top, before establishing in fresh direction, with mixed technicals on lower timeframes supporting the notion.Rising geopolitical tensions that increase demand for safe-haven assets may offer support to Japanese yen for renewed attack at 110 trigger and spark fresh extension of bear-leg from 118.66, Dec 15 peak that is supported by firm bearish setup of daily studies.

Resistance: 111.16; 111.36; 111.60; 112.00
Support: 110.80; 110.53; 110.12; 109.90

GBP/USD

The GBPUSD currency pair recovered a half of Friday's 1.2477/1.2365 fall when it ended trading with 0.9% loss for the day. Strong bearish acceleration was contained by daily Kijun-sen line at 1.2362, which guards another strong support at 1.2346, daily Ichimoku cloud base.Despite expectations that long red daily candle that was formed on Friday's fall will continue to weigh and trigger fresh extension of bear-leg from 1.2555 lower top, the pair managed to stabilize above daily Kijun-sen support and bounce back.Recovery was capped by the top of narrowing daily Ichimoku cloud at 1.2426, which marks solid barrier, together with broken Fibonacci 38.2% retracement of 1.2108/1.2615, 14/27 Mar rally, that is expected ideally limit recovery attempts.Daily MA's in bearish setup and rising bearish momentum, keep negative scenario in play, as daily cloud is twisting at the beginning of next week and may support fresh downside action.However, emerging out of daily cloud is seen as minimum requirement to signal fresh near-term direction.The upper trigger above daily cloud top is daily Tenkan-sen line at 1.2460, regain of which would be seen as strong bullish signal.Traders are looking for Tuesday's release of UK inflation data on Tuesday, for fresh signals.Inflation is holding above projected levels that are seen as good signal for British economy.
Annualized CPI is forecasted at 2.3% in Feb and release at/above this level would be supportive for sterling. On the other side, pound may come under increased pressure on release below consensus that may also cool down the idea of rate hike towards the end of the year.

Resistance: 1.2426; 1.2460; 1.2477; 1.2505
Support: 1.2400; 1.2365; 1.2346; 1.2300

AUDUSD

The Aussie dollar extended strong losses on last Thu/Fri that broke below strong supports at 0.7550 (200SMA); 0.7523 (Fibonacci 38.2% retracement of broader 0.7158/0.7749 rally) and 0.7512 (100SMA) and eventually broke below key short-term support at 0.7489, Mar 09 low, confirming full retracement of 0.7489/0.7747 upleg.The pair hit fresh low at 0.7475, the lowest since Jan 17, above which, near-term consolidation is under way. Firmly bearish technical studies on daily chart favour further weakness, which needs bearish signal on close below 0.7489 pivot. Such scenario would trigger fresh bearish acceleration towards next key support at 0.7449 (base of thick daily Ichimoku cloud) and look for another strong bearish signal on break below this support. Meantime, the pair could extend narrow consolidation above fresh low at 0.7475, which was so far capped by initial barrier – 100SMA.Extended upticks should not exceed next strong barrier, offered by 200SMA, as break here would generate fresh bullish signal and sideline immediate downside threats.

Resistance: 0.7512; 0.7526; 0.7550; 0.7576

Support: 0.7489; 0.7475; 0.7449; 0.7400

GBPCAD

The GBPCAD cross remained in red on Monday and extended strong bearish acceleration from last Thursday's high at 1.6800, to retest former low of Mar 30 at 1.6535. The pair is maintaining bearish pressure that increased on break below 200SMA (1.6694) and 20SMA (1.6610) which now acts as initial resistance and capped recovery attempts during early hours of the American session.Upbeat numbers in Canada's Housing Starts (253.7K in Mar vs forecasted 216K and 214.3K in Feb) helped Canadian dollar to firm further against its British counterpart.Sustained break below 1.6535 pivot is needed to complete Failure Swing pattern on daily chart and generate strong bearish signal for fresh downside acceleration, as support at 1.6535 also marks 61.8% Fibonacci retracement of 1.6311/1.6888 ( Mar 16/27 rally) and acts as strong downside trigger.Broken daily Kijun-sen line at 1.6589 which so far managed to hold upticks, marks immediate resistance, ahead of upper pivots at 1.6668 (daily Tenkan-sen) and 1.6694 (200SMA), break of which would generate fresh bullish signal and turn focus higher.

Resistance: 1.6589; 1.6635; 1.6668; 1.6694
Support: 1.6535; 1.6500; 1.6448; 1.6400

GOLD

Spot Gold slipped further on Monday and hit low at $1247, following last Friday's strong spike to $1270, fresh five-month high and subsequent quick pullback that marked strong upside rejection and left daily candle with long upper wick on Friday. Another false break above key barriers at $1257 (200SMA) and former top of Feb 27 at $1263, weakened near-term structure and introduced fresh downside risk.As Friday's daily candle continues to weigh, gold price lost its initial footstep at $1250 zone and shifted risk lower. Fresh bears off $1270 peak may extend to $ 1243 (rising daily 20SMA / Fibonacci 38.2% retracement of $1195/$1270 rally on repeated close below 200SMA and weak studies on 1 & 4-hour charts.The yellow metal came under pressure on expectations that US Federal Reserve will press ahead with interest rate hikes that counterweighs rising geopolitical concerns over Syri and North Korea that should be boosting demand for safe-haven gold.Gold is expected to struggle at the upside under current circumstances, however, downside attempts should be also limited. Ideally, dips should be contained at $1243 zone in order to avoid deeper pullback on violation of the latter support that may also unmask another key support at $1234 (top of thick daily Ichimoku cloud).On the other side, return above 200SMA would improve the sentiment.Spot Gold ended Monday's trading in long-legged Doji candle that signals strong near-term indecision.

Resistance: 1255; 1257; 1263; 1270
Support: 1253; 1250; 1247; 1243

WTI CRUDE OIL

WTI oil price remained in steep ascend and rose above $53.00 per barrel on Monday, in the third consecutive bullish day. Oil price regained support on hopes of OPEC and non-OPEC oil producers will reach agreement on extension of current program for reduction of oil output that will ease pressure from global oversupply and boost oil prices.Last week's break above psychological $50.00 per barrel level was initial bullish signal, with oil price being boosted by rising geopolitical tensions over North Korea and Syria that also raised tensions between USA and Russia. Such environment is seen ideal for oil prices to rise strongly.WTI contract rose by nearly S1 on Monday, on extension that penetrated into thin daily Ichimoku cloud and broke above barrier at $53.13 (Fibonacci 76.4% retracement of $55.01/$47.06 descend). Fresh bullish acceleration is looking for break above daily cloud (cloud top lies at $53.44) to get fresh bullish signal for acceleration towards key short-term barriers at $55.00 zone (recovery peaks of Jan/Feb 2017).The price is supported by firmly bullish daily and weekly technicals, as well as growing geopolitical tensions. Break above daily Ichimoku cloud would open %53.78 (Mar 07 high) and levels above $54.00, r=en-route towards $55 zone targets.Shallow corrections are seen interrupting rallies, with broken Fibonacci 61.8% barrier, expected to ideally contain and guard 55SMA support at $51.64.

Resistance: 53.44; 53.78; 54.50; 55.00
Support: 52.29; 51.97; 51.64; 51.49

DJIA

Dow ended another day in directionless mode, as Monday's trading was shaped in Doji candle. Choppy Monday's session has ended with slight bullish alignment on gains of energy stocks that offset losses in financial stocks. Quiet trading in past two days is seen on stock markets awaiting corporate quarterly earnings, due later this week. Also, choppy trading was caused by rising geopolitical tensions as trading starts to slow on holiday-shortened week.No significant signals seen from technical studies, as daily chart shows mixed signals on conflicting indicators, however, prevailing bullish bias was dented by recent penetration into daily Ichimoku cloud that was underpinning bullish action since Nov 2016.Stronger bullish signals could be expected by break above daily Kijun-sen line at 20692 and extension above last week's spike-high at 20827.Conversely, weakness through last week's lows at 20460/20450 would soften the structure further and risk fresh weakness.

Resistance: 20659; 20692; 20750; 20827
Support: 20551;20500; 20450; 20400

FTSE 100

FTSE index stayed under fresh recovery high at 7301 on Monday, ending daily trading in red at 7286, after previous two day's strong rally. Growing downside risk that was seen on penetration into daily Ichimoku cloud last week, has been neutralized on strong rally that emerged above rising daily cloud that continued to underpin the advance. Weaker pound also helped the index to recover and shift near-term focus higher.The price is looking key n=barriers at 7311/15 (daily Kijun-sen line / recovery top of Mar 30) that also marks the top of near-term congestion between 7179 and 7315 and 50% retracement of 7444/7179 pullback.Sustained break above 7315 is needed to generate firmer bullish signal for fresh recovery towards targets at 7343 and 7381.Daily Tenkan-sen and daily cloud top at 7252/41 are expected to hold extended downticks.

Resistance: 7311; 7315; 7343; 7381
Support: 7280; 7252; 7241; 7203

DAX

DAX closed in red on Monday after two bullish days at the end of last week, but series of higher g=highs and higher lows formed near-term bull-leg from 12141 (Apr 06 low). The action was contained and remains underpinned by rising 20SMA (currently at 12151). Overall bullish structure on the daily chart is supportive for further recovery, while 20SMA underpins. However, firm break above daily Tenkan-sen at 12275 is needed to v=confirm recovery and open next target at 12307 (Fibonacci 61.8% retracement). On the downside, Monday's low at 12200 marks initial support, followed by pivots at 12151 (20SMA) and 12144 / 41 (daily Kijun-sen / Apr 6 trough), loss of which would generate stronger bearish signal.

Resistance: 12275l 12307; 12346; 12410
Support: 12200 12167; 12141; 12070;

Executive Summary

As the Fed considers what do with its $4.5 trillion dollar balance sheet and the implications these decisions might have on financial markets, we are reminded of Donald Rumsfeld's observation that "it is easier to get into something than to get out of it."

When the Fed first raised rates in this cycle in December 2015, the FOMC announced its intention to continue rolling over its maturing assets until "normalization of the level of the fed funds rate is well under way." At the time, the Fed had just raised rates for the first time in almost a decade, meaning that "well under way" remained quite a ways off. Nearly a year and a half later, the Fed has increased the funds rate two more times and is signaling more hikes on the horizon.

The latest FOMC meeting minutes raised the level of urgency, with some members favoring balance sheet reductions by year-end 2017. Recent commentary by Fed speakers suggests momentum is building for a change. Cleveland Fed President Loretta Mester's comments are a prime example: "Ending reinvestments is a first step toward reducing the size of the balance sheet and returning its composition to primarily Treasury securities over time."

In this report, we consider the factors that will drive Fed balance sheet policy, such as size, composition and timing. We then consider two scenarios under which the Fed may normalize its balance sheet: A baseline scenario, in which maturing assets gradually roll off, and an alternative scenario, in which we explore what it would take for the Fed to consider active sales of its assets.

How Did We Get Here in the First Place?

Prior to the 2008 financial crisis and the ensuing recession, the Fed's asset holdings were about $900 billion, consisting primarily of Treasuries (Figure 1). During the crisis, the balance sheet temporarily held a diverse selection of financial instruments, such as commercial paper and currency swaps, to help mitigate the liquidity challenges that were unfolding in the financial system. Subsequent efforts to drive down long-term interest rates and thus stimulate the economy led to the various "quantitative easing" programs that brought the balance sheet to its current size of roughly $4.5 trillion, comprised mostly of Treasuries and mortgage-backed securities (MBS).

Fed holdings of MBS in such large quantities are without historical precedent. Past holdings of Treasuries, however, can help give us a sense of the role the Fed has played in the market for U.S. Treasuries in more 'normal times'. Perhaps counterintuitively, the Fed's share of the Treasury market plummeted at the onset of the last recession and remained below pre-recession levels for the first couple of years of the recovery (Figure 2). While this may seem odd at first, skyrocketing deficits during this period led to a surge in net treasury issuance (Figure 3). In addition, the Fed's initial purchases were more focused on assets other than Treasuries, such as MBS. Thus, at least initially, the size of the Treasury pie (or the amount of outstanding debt) grew, while the Federal Reserve's slice did not. When the Fed implemented the first and second rounds of quantitative easing (QE), these programs boosted the Fed's holdings of U.S. debt up from a historically low share. The last round of QE helped flip the narrative. QE3 brought the Fed's holdings of U.S. Treasuries, when viewed as a share of total outstanding, up to new highs. This occurred as an improving fiscal outlook simultaneously brought down the pace of new Treasury issuance.

If the Fed unwound its balance sheet and returned its holdings to its average share of the Treasury market from 1982-2007, it would still hold slightly less than $2 trillion in assets, which in nominal dollars would be historically quite high relative to its pre-recession holdings. Returning to the average from the more recent 2000s would yield an even larger balance sheet. Writing for Brookings earlier this year, former Fed Chairman Ben Bernanke discussed balance sheet reductions and maintained that "it's not unreasonable to argue that the optimal size of the Fed's balance sheet is currently greater than $2.5 trillion and may reach $4 trillion or more over the next decade."2 These estimates highlight that the Fed is unlikely to reduce its holdings to anywhere near pre-recession levels. Although the Fed's total balance sheet remains quite large, the economy has 'grown into' the Fed's balance sheet over the past decade, a phenomenon that should continue in the years ahead. Even still, if the rough estimate for the appropriate size of the balance sheet is somewhere in the neighborhood of $2 trillion-$2.5 trillion, there is clearly still scope for the Fed to begin reductions at some point in the near future.

The Path Forward: What Might the Road to "Normal" Look Like?

Fed guidance on the timing and structure of balance sheet reduction has been fairly tight-lipped until recently. However, based off of the Fed's "Policy Normalization Principles and Plans,"3 the following points appear likely to serve as key guidelines:

• "The Committee intends to reduce the Federal Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the System Open Market Account (SOMA)."
• "The Committee currently does not anticipate selling agency mortgage-backed securities as part of the normalization process, although limited sales might be warranted in the longer run to reduce or eliminate residual holdings. The timing and pace of any sales would be communicated to the public in advance."
• "The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy."

In short, the Fed appears set to 1) allow maturing assets to roll off rather than outright sell securities and 2) gradually return its holdings to primarily Treasury securities over the long-run. Given this, we outline two illustrative scenarios to highlight the different paths ahead.

Scenario 1: The Passive Approach

Under this scenario, which we consider our baseline, the Fed will cease reinvesting the proceeds of its maturing securities, passively winding down the balance sheet in the process. As illustrated in Figure 4, more Treasury securities come due in 2018 than any other year. With a slightly longer time horizon, the Treasuries held on the Fed's balance sheet are front-loaded; nearly one-half of the Fed's $2.4 trillion in Treasury holdings come due between now and 2020. The maturity schedule leaves the Fed well-positioned to adopt this passive approach while still making a material impact on the size of its balance sheet. This route is also consistent with the Fed's stated goal of avoiding outright asset sales for the time being and is thus the least likely policy to roil financial markets. In an effort to smooth the process and avoid another "taper tantrum" episode, the initial reductions may entail reinvesting a significant fraction of the maturing assets. For example, for every $100 that comes due, the Fed could choose to reinvest $75 of that original $100, slowing the pace of balance sheet reduction more than the maturity schedule would suggest. Then, as economic conditions warrant and financial markets adjust to this new change in monetary policy, the Fed could begin to reduce the fraction of maturing proceeds it reinvests.

For Treasuries, this approach is fairly straightforward. On the MBS side of the portfolio, however, the balancing act is a bit more complicated for the Fed. As highlighted above, over the long-run the Fed would prefer to hold only Treasury securities to minimize its influence on the private allocation of credit. However, unlike the fixed maturity schedule of Treasuries, the passive approach to reducing MBS holdings leaves the Fed at the whim of forces outside its control. Prepayment on MBS, due to refinancing, mobility, downsizing/upsizing, etc., all influence the pace at which these securities will mature. Figure 5 illustrates a hypothetical scenario of how Fed holdings of MBS could evolve if they were allowed to pay down without being reinvested.4 At current rate levels, about $180 billion could pay down in 2018, a sizeable amount relative to the approximately $225 billion in net MBS issuance expected per year. This reinforces the notion that the Fed will likely choose to reinvest a share of the MBS proceeds to reassure financial markets that the balance sheet reductions will not be too sharp and the impact on markets rates will be more limited.

In our view, the Fed most likely will propose starting the process by allowing maturing securities to roll off by year's end, through a combination of MBS and Treasury reductions. In order to prevent a taper tantrum repeat, the Fed will likely try to signal this well in advance and choose to reinvest a sizable percentage of the maturing assets, smoothing the transition. The comments from Cleveland Fed President Mester and the latest Fed minutes offer examples of this messaging. If all proceeds according to plan and the economy continues to improve, the Fed would then gradually reduce the share of its reinvestments to normalize further.

Scenario 2: What Would It Take for the Fed to Commit to Outright Sales?

Given the above scenario, under what circumstances might the Fed consider outright sales of its assets? We doubt that the Fed will sell a meaningful quantity of MBS or Treasuries any time soon. Our interest rate strategists think that sizable sales could unnerve these markets. Indeed, although the Fed has explicitly stated it intends to wind down the balance sheet through ceasing reinvestments, it has also admitted that there is a chance that "limited sales [of MBS] might be warranted in the longer run to reduce or eliminate residual holdings."

A sharp change in the economic outlook could warrant asset sales of Treasuries, MBS or a combination of the two. If, for example, a sizable economic stimulus package ramped up economic growth and stoked faster inflation, the Fed might consider a more active approach to normalizing monetary policy beyond the fed funds rate. Alternatively, a shift in the composition of the FOMC could also lead to a more active approach than is currently anticipated. There are currently two open spots on the FOMC, and soon to be a third with the departure of Governor Tarullo. With Chair Yellen's term set to end in February 2018 and Vice-Chair Fischer's term ending that summer, President Trump and the Republican Congress have the opportunity to dramatically reshape the FOMC in the years ahead.

If the new Board members adopted a more hawkish/traditional approach that sought to return the Fed's balance sheet to a much smaller portfolio comprised primarily of Treasuries, this could lead to a more rapid reduction in MBS holdings. As illustrated in Figure 5, even if all maturing MBS over the next five years were allowed to roll off, at current rate levels MBS holdings could still be nearly $1 trillion, a far cry from pre-recession normalcy. The incoming policymakers could view this as unacceptably slow and ramp up the process in order to more rapidly exit the MBS market. Again, although this is not our baseline scenario and would likely play out over several years, it bears close watching given the Fed's competing goals of returning to primarily Treasuries holdings over the long-run and a desire to gradually and passively reduce the balance sheet without disrupting financial markets, the housing market or the overall economy.

Other Balance Sheet Considerations: The Greenspan Conundrum Could the Balance Sheet Offer the Fed Greater Flexibility?

In testimony before Congress in 2005, then Federal Reserve Chairman Alan Greenspan described the difficulty the Fed was encountering as longer term interest rates were not especially responsive to increases in the fed funds rate, a situation Chairman Greenspan famously referred to as a "conundrum."5 Later in that same year, then Governor Ben Bernanke expanded on the potential causes of the Greenspan conundrum, citing an oversupply of investment dollars from foreign investors, which drove longer dated bond prices up and pushed yields lower.6 Arguably a similar situation exists today and this foreign demand for longer-dated Treasuries becomes even more pronounced when volatility contributes to a flight-to-safety move by investors.

The flattening of the yield curve first observed by Greenspan in 2005 eventually gave way to an inverted yield curve at various points of time between 2005 and 2007 (Figure 6). Since 2014, the yield curve has been flattening again, with the spread between the yields on the 10-year and two-year Treasury returning to the level that prevailed at the time of the Greenspan conundrum.

Our interest rate forecast has short term rates rising faster than longer term rates and thus implies a continuation of this flattening trend. In this scenario, the swollen balance sheet of today's Fed offers some additional monetary policy flexibility vis-à-vis the Fed of the Greenspan era. Rather than waiting for the Treasuries it holds to come to maturity, the Fed might instead sell longer-dated Treasury securities on the open market. All else equal, the additional supply should push prices down and drive yields higher at the long end of the curve.

Relationship between Fiscal & Monetary Policy Isn't a One-Way Street

There are a number of Republican members of Congress who would like to see the Fed get out of the housing market and unwind some or all of its $1.8 trillion portfolio of MBS and agencies. In many instances, these are members of Congress who also place a high value on balancing the federal budget.

As Figure 7 shows, Congressional Budget Office estimates suggest that the fiscal budget deficit is poised to worsen over the next few years. Without making a value judgement about whether or not the Fed "should" maintain a large balance sheet, the Fed's large holdings currently help reduce the budget deficit. In an environment of rising deficits and policy proposals for which finding the funding is often a major challenge, reduced remittances to the Treasury cannot be ignored. As illustrated in Figure 8, Fed earnings remitted to the Treasury over the past 12 months add up to roughly $90 billion. Without those remittances, last year's fiscal budget deficit would have been 16 percent larger.

Furthermore, despite a debt-to-GDP ratio that has doubled since the Great Recession began, net interest costs as a share of GDP have remained historically low (Figure 9). With monetary policy tightening likely driving interest rates higher, this represents yet another way in which monetary policy can influence the fiscal side of the economic policy equation.

When the Levee Breaks

We do not expect the Fed to fully liquidate its balance sheet or fully 'normalize' its portfolio holdings. The next recession is coming. The next recession is always coming, and our baseline expectation is that this cycle has at least a couple more years to go. However, we would be remiss not to point out that in three months, the length of the current expansion will be eight years. The longest expansion on record is 10 years.

The Fed has lowered its estimates of what it considers the appropriate level for the fed funds rate in the longer-run from 4.25 percent in 2012 to 3.0 percent today.8 The ultimate terminal fed funds rate will likely be lower when the current cycle comes to an end that it has been in prior economic cycles. With limited scope for the Fed to cut rates when the next recession comes along, whenever that may be, the Fed may have to go back to the well of quantitative easing. This could entail resuming reinvestments or even returning to asset purchases, depending on what economic conditions warrant.

Normalization of the Fed's balance sheet is an important consideration and will become a focus of both monetary policymakers and financial markets in the months ahead. Monetary policymakers will be challenged to find a balanced path that begins the process of unwinding years of unconventional monetary policy while simultaneously keeping the economic expansion chugging along. The various scenarios considered in this paper are offered to help decision makers frame their thinking and make informed decisions as this process unfolds.

The Canadian dollar is trading higher against the US dollar on Monday (1.3333) after another supply disruption in Libya has boosted oil prices. Geopolitical risk continues to be a factor as US President Donald Trump called in an airstrike on Syrian targets when he was hosting Chinese President Xi Jinping. The loonie lost ground on risk aversion on Friday despite a stronger than expected Canadian jobs report. 19,400 jobs were added in March and the unemployment rate rose slightly as more people are seeking to re-enter the workforce. The same day the US jobs report missed expectations but became a non-factor as targets looked to the Russia-US reactions to the attack on Syria triggering a flight to safety that kept the USD bid.

Earlier this morning housing starts in Canada jumped 254,000 beating the forecast of 212,000 and adding more pressure on what is already an overheating market. March housing starts were at their highest level since 2007 according to the Canada Mortgage and Housing Corporation (CMHC). Vancouver is seen as starting to cool off in what could be a direct reaction to updated mortgage rules, while Toronto continues to trend higher.

The Bank of Canada (BoC) will publish its monetary policy statement on Wednesday, April 13. The majority of analysts are in consensus that the central bank won’t raise rates. After a proactive 2015 where it cut rates twice ahead of the drop in oil prices, the BoC spent 2016 on the sidelines as a newly elected Liberal government announced a stimulus program. Governor Poloz has tried to talk down the currency in order to boost exports, but there are some fundamental signs that the economy is recovery which might bring about higher rates sooner rather than later.

The USD/CAD lost 0.508 percent in the last 24 hours. The pair is trading at 1.3337 as the loonie advances thanks to the bump in oil prices. The USD has lost some ground at the start of the week as risk appetite has returned to markets. The price of oil has helped the CAD appreciate as well as some strong fundamental data.

Investors will be looking at the Bank of Canada on Wednesday for more insight into the stance of the central bank. Inflation is rising, but the BoC has assured markets that there is no risk of overheating but as the U.S. Federal Reserve continues its rate hike path it will put further pressure on Poloz to keep up. For now the failure of the Trump administration to pass the healthcare reform policies has reduced the anticipated number of US rate hikes as the inflation boost from a tax reform or infrastructure spending might take longer than expected before Trump was inaugurated.

Oil prices gained 1.376 percent on the Monday session. The price of West Texas is trading at $52.73 after Libya’s largest oilfield is still offline after another outage. Geopolitical risk combined with the supply disruption to keep driving oil prices higher. Russia is also hinting at going along with an extension of the Organization of the Petroleum Exporting Countries (OPEC) production cut agreement. The deal has been the biggest factor in bringing stability to crude prices after the near free fall seen at the beginning of 2016.

OPEC and other major producers have joined in an unprecedented deal with very strong compliance but oil prices have been kept in check by the downward pressure of higher production from shale producers who are not part of the agreement. US inventories have hit record highs and US exports have regions hit by the OPEC oil cuts supplied with crude.

Market events to watch this week:

Monday, April 10
4:00pm USD Fed Chair Yellen Speaks
Tuesday, April 11
4:30am GBP CPI y/y
Wednesday, April 12
4:30am GBP Average Earnings Index 3m/y
10:00am CAD BOC Monetary Policy Report
10:30am USD Crude Oil Inventories
11:15am CAD BOC Press Conference
9:30pm AUD Employment Change
Tentative CNY Trade Balance
Thursday, April 13
8:30am CAD Manufacturing Sales m/m
8:30am USD PPI m/m
8:30am USD Unemployment Claims
10:00am USD Prelim UoM Consumer Sentiment
Friday, April 14
8:30am USD CPI m/m
8:30am USD Core CPI m/m
8:30am USD Core Retail Sales m/m
8:30am USD Retail Sales m/m

Nothing, Zilch, Nada. That's just the reality of where markets are at in 2017.

We spoke about 'life going on' after the Paris terror attacks and as much as the human being inside you wants to feel something when there is an attack or a major global superpower intervenes in a civil war, to markets it really just doesn't matter anymore.

The world has changed and whether we like it or not, human beings (and as a result, markets), are completely desensitised.

After the US launched missiles toward key government targets in retaliation for chemical weapons attacks on their own people, markets reacted in a way I haven't seen for a long time. They actually took notice! Risk currencies tanked and commodities such as Gold rocketed.

But being 2017 and as we keep saying on this blog, markets just don't care anymore:

XAU/USD 15 Minute:

As you can see on the 15 minute chart with daily period separators turned on for clarity, the so called 'rocket move' was completely retraced before the end of the session. That's a rocket? Not a chance.

Heck, look at it now we're into the following week and Gold is actually lower than where it started! It shouldn't shock me because we've seen it happen enough, but it still does. Being a human being rather than a robotic trader is a hard trait to shake.

All this shows is the only thing that matter are your levels.

Take a look at the following daily chart:

XAU/USD Daily:

As you can see, Gold is still holding the resistance level that we have been following on the blog.

So long as that higher time frame resistance level continues to hold, the play is to sell short term pullbacks. Something we'll continue to look for here and on the @VantageFX Twitter account.

Mark your levels, trade your levels. It really is all that matters.

The long position entered in AUD/USD earlier at 0.7645 was stopped at 0.7605 and the pair has continued heading south throughout last week, we then ventured long again at 0.7525 in anticipation of a possible rebound and the position is still holding at the moment.

We entered another long position in USD/CAD at 1.3375 but in view of the retreat occurred late last week, we exited the position around break-even.

In short, 3 positions were entered with total loss of 40 points and the positions are listed below.

22 Mar : AUD/USD - Long at 0.7645, exited at 0.7605 (- 40 points)
  7 Apr : AUD/USD - Long at 0.7525,
  7 Apr : USD/CAD - Long at 1.3375, exited at 1.3375 ( 0 point)

|                 AUD        EUR/JPY          EUR/GBP          CAD
Jan             - 15             -275                - 35            -120
Feb           + 140            -17                  - 40             +11
Mar            - 20            +115                +132           - 19
Apr                  
May          
Jun           
Jul            
Aug          
Sep              
Oct           
Nov         
Dec                                                                                                                                               
Y-T-D        + 105           - 177               + 57            + 38

In part due to the release of US NFP data, only one position was entered in GBP/USD at 1.2465, however, the recovery from 1.2419 turned out to be slightly stronger than expected, our stop at 1.2500 was hit but price met renewed selling interest at 1.2506 and dropped in line with our bearish expectation, price eventually fell to as low as 1.2365 before recovering.

No position was entered in other currency pairs last week.

In short, only 1 position was entered among all 4 currency pairs with total loss of 35 points and the position is listed below:

4 Apr : GBP/USD - Short at 1.2465, exited at 1.2500 (- 35 points)

|                 JPY             EUR             CHF            GBP

Jan          + 167             - 85              - 10            + 50
Feb          + 200            +150             +93            - 59
Mar              -23              -70               -23            - 35
Apr                                                                     - 35
May         
Jun          
Jul           
Aug         
Sep             
Oct         
Nov        
Dec                                                                                               
Y-T-D       + 344            - 10                +60           -79     

USD/CHF - 1.0077

Most recent candlesticks pattern : N/A

Trend                                    : Near term up

Tenkan-Sen level                  : 1.0092

Kijun-Sen level                    : 1.0085

Ichimoku cloud top                 : 1.0050

Ichimoku cloud bottom              : 1.0050

Original strategy :

Buy at 1.0030, Target: 1.0130, Stop: 0.9995

Position : -

Target :  -

Stop : -

New strategy  :

Buy at 1.0000, Target: 1.0100, Stop: 0.9965

Position : -

Target :  -

Stop : -

As the greenback has retreated after rising to 1.0108 today, suggesting consolidation below this level would be seen and initial downside risk is for pullback to 1.0050, then towards support at 1.0026, however, reckon 0.9995 support would contain weakness and bring another rise later, above indicated resistance at 1.0108-09 would extend recent upmove from 0.9813 towards 1.0140-45 but loss of upward momentum should prevent sharp move beyond another previous resistance at 1.0171, risk from there has increased for a retreat to take place later. 

In view of this, would not chase this rise here and would be prudent to buy dollar on subsequent pullback as support at 0.9995 should limit downside. Below 0.9970 (50% Fibonacci retracement of 0.9831-1.0108) would abort and signal top is formed instead, bring correction to support at 0.9948.