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Fed minutes spark bond market sell-off

Bond markets must quickly adapt to a likely much earlier and faster reduction of central bank balance sheets.

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Having fallen behind the curve on inflation and embarrassed itself by lecturing the market on the correct definition of transitory, the US Federal Reserve is now trying to sprint ahead again by signalling a faster and earlier reduction of its swollen balance sheet than bond-market participants had expected.

Released on Wednesday, the minutes of the December meeting of the Federal Open Market Committee (FOMC) show that almost all participants agreed it would be best to begin balance-sheet reduction soon after the first rise in interest rates – which some dealers expect as soon as March and that is fully priced in for May.

The bond markets are now pricing in three rate hikes this year, in line with the Fed’s own median dot path. Normally markets position for the Fed doing more or less than consensus. This unanimity is unusual. But it does not presage market calm: quite the reverse.

In the only previous episode of quantitative tightening, the Fed waited two years after the first rise in rates before running down its balance sheet from 2017. But this time its balance sheet is much bigger both in nominal terms and as a percentage of GDP, and has a much shorter average duration.

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