Wall Street sees Fed balance sheet normalization plan by year end

By Richard Leong

NEW YORK (Reuters) - Wall Street's top banks see the Federal Reserve laying out by year end its plan to scale back reinvestments in Treasuries and mortgage-backed securities in order to begin shrinking its $4.5 trillion balance sheet, a Reuters poll showed on Friday.

Five of 15 primary dealers, or banks that do business directly with the U.S. central bank, expected the Fed to start paring reinvestments by year end, while the rest forecast the central bank would do so by the end of the second quarter of 2018.

The median view of 11 dealers was for the Fed to eventually shrink its balance sheet to $2.75 trillion.

As the U.S. central bank seems prepared to tackle unwinding its bond holdings, primary dealers see the Fed raising interest rates two more times by year end and three times in 2018.

Fed policymakers have turned their focus to paring the central bank's massive bond holdings, as shown in the minutes of their March policy meeting released on Wednesday.

Last month, the Fed raised rates by a quarter percentage point to 0.75 percent-1.00 percent amid signs of an improving U.S. economy and stock prices reaching record highs.

The central bank amassed its Treasuries and MBS during three rounds of large-scale purchases known as quantitative easing, which was aimed to lower long-term borrowing costs and combat the repercussions of a severe recession that was exacerbated by the global credit crisis more than eight years ago.

On Wednesday, the Fed held $2.46 trillion in Treasuries and $1.77 trillion in MBS.

While the Fed has longed to reduce those holdings, it has been reluctant to do so due to concerns that buying fewer bonds could cause a spike in mortgage rates and other long-term borrowing costs and hurt an economy that has been stuck at a 2 percent growth rate.

The Fed's willingness to embark on this change came after Donald Trump's surprise U.S. presidential victory in November, which unleashed hopes of tax cuts, looser regulations and infrastructure spending to bolster business investments and job growth.

That optimism has cooled in recent weeks after Trump and the Republican-controlled U.S. Congress failed to pass healthcare reform. This led investors to scale back expectations on tax cuts and infrastructure spending in 2017.

Federal fiscal stimuli, analysts say, would cushion tighter financial conditions from interest rate increases and fewer bond purchases from the Fed.

A disappointing March jobs report caused traders to briefly slash their bets on a June rate hike on Friday before comments from influential New York Fed chief William Dudley on rate increases and balance sheet normalization revived those bets.

"This report doesn't take away from the Fed's near-term outlook on the economy," said Sam Bullard, senior economist at Wells Fargo, a primary dealer in Charlotte, North Carolina.

In the latest Reuters poll, 13 of 17 dealers saw the Fed hiking rates to 1.00-1.25 percent by the end of the second quarter, compared with 11 of 17 dealers in a March 15 poll.

Eight of 17 dealers saw the Fed lifting rates to 1.25-1.50 percent by the end of the third quarter, while 16 of 17 expected that rate range to be reached by year end.

(Reporting by Saqib Ahmed, Karen Brettell, Sinead Carew, Sam Forgione, Richard Leong, Chuck Mikolajczak, Dion Rabouin and Rodrigo Campos; Editing by Chizu Nomiyama and Meredith Mazzilli)