Before 2008, monetary policy went a little something like this: The Fed met periodically, voted on overnight interest rates, and the New York Fed bought and sold stuff to keep rates as close to that target level as possible. But after the financial panic came "unconventional" monetary policy -- quantitative easing, or QE.
Under QE, the Fed bought a smorgasbord of long-term assets in an effort to reduce long-term interest rates and juice growth. Since 2013, the Fed has been trying to get back to "normal" -- first by tapering (and eventually ending) QE, then by hiking short rates a smidge.
Wednesday, in conjunction with its fourth fed funds target-rate hike, the Fed released its loose plan for another step: Reducing the size of its balance sheet. And on cue, people are worried the economy can't survive without artificial life support. Yet, like the rate hikes and QE taper before it, another round of monetary policy normalization shouldn't disrupt the bull market. Rather, getting back to normal could do wonders for sentiment, giving investors' animal spirits a lift.
QE was born on Black Friday 2008, when the Fed first announced it. Over the next six years, the policy added $3.7 trillion in US Treasury bonds and mortgage-backed securities to the Fed's balance sheet.[i]
While the Fed progressively slowed its bond buying in 2014 -- the dreaded taper -- and then stopped QE altogether that October, the central bank has since been reinvesting the proceeds of maturing bonds, keeping all of this supposed stimulus on its balance sheet. Now Fed people are signaling they will start reducing it at some point fairly soon, perhaps this year.
Exhibit 1: Feeling Bloated
Source: Federal Reserve, as of 6/14/2017. Federal Reserve System Total Assets, weekly, 12/18/2002 - 6/7/2017.
Worries abound over what happens when the Fed shrinks its balance sheet. Perpetually perplexed pundits fear removing support would collapse money supply, spike long-term interest rates, destabilize financial markets and/or wallop economic growth.
Some have played around with Excel to make the Fed's balance sheet resemble stocks' rise since March 2009, implying that as goes the balance sheet, so goes the S&P 500 -- perpetuating the myth that QE alone drove stocks up. In reality, as we've explained several times, QE flattened the yield curve and likely hurt far more than it helped, making stocks' rise a "despite QE," not "because of QE," phenomenon.
All these concerns remind us of the outcry when the Fed was jawboning about the first rate hike in 2015 and QE tapering in 2013. None of their fearful forecasts bore fruit, and markets fared fine. We see no reason why this time is any different.
The Fed Might Run off, but Investors Shouldn't
While sudden huge shifts in monetary policy -- including swift balance sheet changes -- raise the potential for errors, the Fed's plan is far from a major shift. It is among the most gradual ways possible to unwind this. For one, it won't sell. It will simply cease reinvesting the proceeds of maturing bonds at a pre-determined rate. Here is that rate, according to the Fed's policy statement:
For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.
The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve's securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.
The maximum $50 billion monthly rate is about 1% of the Fed's current balance sheet. The starting rate, $10 billion per month, is 0.2%. As the Fed noted, this sure seems gradual.
While gradual is fine, balance sheet unwinding fears seem like a direct-to-video sequel of QE taper fears. Back in May 2013, people went nuts when Ben Bernanke first hinted the Fed might taper QE sooner rather than later. Pundits were convinced the economy would fall apart without monetary support, and global markets with them.
The Fed announced the actual taper in December 2013, started reducing bond purchases in January, and finished winding down in October 2014. Markets did not melt down. Treasury yields rose in the run up to the taper announcement -- proving once again that markets discount widely expected events -- but fell throughout the taper. 10-year yields -- which move opposite prices -- fell from 2.9% on Taper Day to 2.3% at the taper's end (see Exhibit 2).[ii]
From there through July 2016, yields declined to a record low, even though the Fed wasn't buying $45 billion in Treasury bonds each month. Other central banks were still doing QE, reducing long rates globally, and driving demand for relatively higher-yielding Treasuries. The S&P 500 gained 10.7% between Bernanke's May 22 speech and the actual taper announcement on December 18 -- the period known as "taper talk."[iii] It gained another 11.4% during the taper itself, and is presently up 30.2% since the Fed last added to its balance sheet.[iv]
The global supply and demand picture hasn't really changed since then. If the Fed were to stop reinvesting proceeds of maturing bonds tomorrow, we suspect other investors would be delighted to snap them up. The world is still awash in negative-yielding debt. We suspect a large portion of those holders enviously eye positive-yielding Treasuries.
Demand for US Treasuries is broad and multifaceted. The Treasury market is the biggest and most liquid in the world, where "safe assets" used for trade, collateral and capital requirements are a hot ticket. Treasuries are the bedrock asset of the global financial system. Barring a misstep, the Fed slowly shrinking its balance sheet will likely prove benign.
Markets should have no problem absorbing the loss of a buyer, even if it's the world's largest Treasury holder. Banks, pension funds, foreign governments, other institutional investors and individuals are all eager buyers. Long rates aren't guaranteed to shoot up. They may even fall a smidge, depending on what global markets look like when the time comes.
Instead of fearing what the media says may happen when the Fed puts yet another wonky instrument back in the toolbox, consider what may happen when, for the third time, worries are proven wrong. When there are few, if any, ways left to credit the Fed for the bull market, people might finally realize monetary policy has little role in stocks' ascent and the economy doesn't need Fed stimulus. As they take this next step and the economy and markets don't implode, confidence should get a nice boost, making investors ever more eager to bid up stocks.
[i] Source: Federal Reserve, as of 1/27/2017.
[ii] Source: St. Louis Fed as of 1/27/2017. QE officially ended 10/29/2014.
[iii] Source: FactSet, as of 1/26/2017. S&P 500 Total Return Index, 5/22/2013 - 12/18/2013.
[iv] Ibid. S&P 500 Total Return Index, 12/18/2013 - 10/29/2014 and 10/29/2014 - 6/13/2017.
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