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Goldman Sees "Risk" Of Fed Rate Hike At Every Meeting, Predicts $2.5 Trillion In Balance Sheet Shrinkage

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by Tyler Durden
Sunday, Jan 23, 2022 - 06:15 PM

An interesting dynamic has emerged on Wall Street: on one hand, amid rising speculation that the Fed may hike as much as 50bps and/or announce an early end to the taper in this week's FOMC meeting, some banks like JPMorgan are starting to see a "pivot" emerge and in the bank's latest Fed outlook, it said that the Fed  "is only likely to ratify expectations next week and not surprise market participants with another hawkish pivot."

The reason is that while the bank is certainly concerned about rising inflation, JPM is growing increasingly concerned about the slowdown in the economy, writing that the JPMorgan's Economic Activity Surprise Index (EASI) "has swung sharply into negative territory in recent weeks, indicating data have underperformed relative to consensus expectations."

It also why the bank slashed its GDP forecast and now predicts that "growth decelerated from a 7.0% q/q saar in 4Q21 to a trend like 1.5% in 1Q22" amid a sharp slowdown in retail sales, the Empire Fed Manufacturing survey and the surge in initial claims. And while one can easily blame those on the now fading surge in Omicron cases, BofA's Michael Hartnett made a more ominous observation, concluding that the "End of Pandemic = US Consumer Recession" because "inflation is annualizing 9%, real earnings falling a recessionary 2.4%, stimulus payments to US households evaporating from $2.8tn in 21 to $660bn in 2022, with no buffer from excess US savings (savings rate = 6.9%, lower than 7.7% in 2019 & and the rich hoard the savings), and record $40bn MoM jump in borrowing in Nov'21 shows US consumer now starting to feel the pinch."

And if the US consumer - responsible for 70% of GDP - is done, so is last year's economic growth miracle. Which by the way is not lost on the market, where the divergence between market expectations for how many times the Fed can hike and the Fed's own hawkish dot plot which sees a total ten 25bps rate hikes, is growing by the day. In fact, as shown by both OIS and the Fed Fund Futures, the market now expects the Fed to cut rates some time in 2024 (Incidentally, BofA's Hartnett expects a recession scare in the second half of 2022 and the first rate cut in 2023, something the market is still behind the curve on).

But while a growing number of banks are starting to oppose the blind hawkish narrative, some are still pushing the hawkish narrative in some cases beyond an absurd extreme.

Case in point: Goldman Sachs, which overnight reiterated its base case of 4 rate hikes in 2022 (starting in March) and balance sheet runoff (starting in July)...

... warns that due to surging inflation - the same inflation surge which Goldman completely failed to predict in 2021 as the following creeping increase to the bank's year-end forecasts shows...

... now says that "recent developments have made us more concerned about the inflation outlook."

  • First, "Omicron could prolong supply-demand imbalances and delay price normalization in the goods sector" (just as Zero Hedge said in December).

  • Second, wage growth is still running at a 5-6% annualized pace months after enhanced unemployment benefits expired.In coming months, the inflation dashboard is likely to show lingering supply chain problems, hot wage growth, strong rent growth, very high year-on-year core PCEand especially core CPI inflation, and very high short-term inflation expectations

To Goldman, "this means that the FOMC is likely to be looking at a hot inflation dashboard at its next few meetings, with well above-target year-on-year core PCE and especially core CPI inflation and pressure beneath the surface too. Supply-side problems including labor shortages and supply chain disruptions are likely to last a while longer. And more importantly, wage growth, rent growth, and short-run inflation expectations are all likely to remain too high for the FOMC’s comfort."

As a result, while not its base case, Goldman sees a risk that "the FOMC will want to take some tightening action at every meeting" until the surging inflation picture changes. This, Goldman's chief economist Jan Hatzius says, raises the possibility of a hike or an earlier balance sheet announcement in May, and of more than four hikes this year.

Hatzius also notes that as a result of the limited tightening in financial conditions so far - apparently he is unaware of the bloodbath across most markets even if the S&P is down less than 10% from its all time highs - the bar for hiking more than the four times the market has already priced would be lowered.

In other words, it's almost as if Joe Biden is demanding that Powell crash the market, just as we have been joking for the past few weeks even if it no longer looks like a joke.

That said, Goldman notes that if Fed officials "do decide that they need to be more aggressive, Goldman believes that they would likely hike by 25bps at consecutive meetings rather than hike by 50bp." Yet even that would be a major step, and few Fed officials appear to be considering it for now. Separately, Hatzius also notes that market participants have debated the possibility of the FOMC ending asset purchases at the January meeting, rather than reducing the pace to $30bn in February and ending purchases in March. Here too Goldman does not share the market's skepticism, and says that "if Fed officials planned to do this they would have said so by now."

As a result of these considerations, Goldman has revised its Fed scenario analysis "to reflect this possibility of faster rate hikes in response to higher inflation. The probabilities we assign to possible paths for the funds rate imply that the risks are tilted somewhat to the upside of our baseline and that our views remain more hawkish than market pricing."

Finally, addressing the topic of balance sheet runoff, Hatzius believes that "it is likely to be quicker than last cycle, mainly because
there is much further to go." Looking ahead, Goldman expects peak runoff caps of $60bn per month for Treasury securities and $40bn per month for mortgage-backed securities, or $100bn total, with at most a brief ramp-up period.

This pace of runoff would shrink the balance sheet from $8.8tn today to $6.1-6.6tn over 2-2.5 years, or a whopping $2.5 trillion in 2 years (which is not too far off from Deutsche Bank's $3 trillion QT forecast). Good luck with that especially since the next recession will hit long before the two years is over and force the Fed to not only resume QE but to launch NIRP.

Laughably, Hatzius also "calculates" that $2.5 trillion in balance sheet reduction would raise 10yTreasury yields by just 30bp, and would have roughly the same impact on the economy as a 30bp rate hike.

As usual, the full Goldman note is available to pro subscribers.

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