UBS says the Fed is likely behind the curve in shrinking its balance sheet

The Federal Reserve is behind the curve when it comes to shrinking the balance sheet, according to UBS Global Wealth Management’s Kelvin Tay. 

Fed Chairman Jerome Powell said Tuesday that he expects a series of interest rate hikes this year, along with other reductions in the extraordinary help the central bank has provided during the pandemic. 

“If you take a step backwards and you listen to what he said. He hasn’t actually acknowledged that the Federal Reserve is actually behind the curve — but they certainly are,” Tay told CNBC’s “Squawk Box Asia” on Wednesday. 

Tay noted U.S. stock markets are doing relatively well and corporate earnings in the second and third quarter of last year were also at “multi-decade highs.”

“And at this point in time they are still printing. So you must be wondering why they are still printing at this level, right?,” he said, adding key developments going forward will be how fast and how much the Fed shrinks its balance sheet.

Investors are awaiting Wednesday’s key inflation data to assess the economic picture and the Fed’s next move.

The U.S. central bank spooked investors last week after minutes of its December meeting signaled members were ready to tighten monetary policy more aggressively than previously expected.

It indicated it may be ready to start raising interest rates, dial back on its bond-buying program, and engage in high-level discussions about reducing holdings of Treasurys and mortgage-backed securities.

To get ahead of the curve, Tay said the Fed could start normalizing the balance sheet earlier than expected.

“There is a 75% chance that the Federal Reserve will hike in March when tapering ends. The debate now is whether it’s two or three hikes where the market is concerned. It could be four hikes this year as well,” he said.

He added there could be complications, especially if supply chain pressures ease in the coming months as this could reduce inflation expectations going forward.

“That means the Federal Reserve may not have to start normalizing the balance sheet as early as we actually expect,” Tay explained, adding the situation at this stage remains fluid.

Tay also underlined the Fed’s faster policy tightening cycle is likely to impact Asian countries, especially emerging markets in the region. 

“If your U.S. Treasury yields on a 10-year basis rise up to about 2% and 2.5%, then the yields on this part of the world where the government sovereigns are concerned will have to behave accordingly,” he said. This will affect some of the economies in Asia given their higher debt levels, he added.

In 2013, the Fed triggered a so-called taper tantrum when it began to wind down its asset purchase program. Investors panicked and it triggered a sell-off in bonds, causing Treasury yields to surge.

As a result, emerging markets in Asia suffered sharp capital outflows and currency depreciation, forcing central banks in the region to hike interest rates to protect their capital accounts.

Tay said aggressive Fed policy could potentially slow the economic recovery in Asia.

“That’s not something that you want at this point in time. Because at this point in time, a lot of the economies here are still struggling to recover from the Covid-19 pandemic,” he noted.