In their much anticipated meeting this week, the Fed did what Wall Street wanted – Do Nothing. It kept its key interest rate steady and decided to wait at least a couple more months before starting to scale back its $4.5 trillion balance sheet. This was interpreted as a signal from policymakers that they aren’t overly concerned about high valuations and equity prices. All the major stock indices promptly hit new all-time highs soon after the meeting.
Of significance, however, was Fed’s comment that there will be a change in their reinvestment policy “relatively soon”. This implies that, by the next Fed meeting in September, we could see a gradual move away from the Fed’s current stance of reinvesting all principal from maturing bonds, potentially raising long-term interest rates.
A quick background on Fed’s balance sheet problem – In response to the Great Recession of 2007-09, the Fed began a program, known as “quantitative easing”, aimed at injecting money into the economy following the devastation of the financial crisis. The Fed bought Treasuries and mortgage-backed securities, now valued at $4.5 trillion. These bonds carry various maturity dates. When the bonds reach maturity, current policy called for reinvesting the proceeds and rolling over the bonds, thus keeping interest rates low. Now, with the economy in much better shape, the Fed has begun to ponder a change in its policy to keep reinvesting the money when bonds mature. But, just the act of allowing the bonds to run off naturally, will in itself begin to drive up long term interest rates. And, therein lies the conundrum.
In the meantime, the weak dollar, low interest rates and low inflation have been a boon to earnings of domestic and multinational US companies alike, pointing to a strong Q2 earnings season that got underway last week.
Future Wealth’s View
While Wall Street celebrates the Fed decision to be “hands off” once again, at Future Wealth, we believe that when the Fed begins winding down its balance sheet, things could be more disruptive than Wall Street is currently projecting. The effect of fully reversing the quantitative easing that has taken place since 2007, a period in which the Fed’s balance sheet has risen from $0.9 trillion to $4.5 trillion, could be disastrous if it is not managed judiciously.
But, of course, the Fed knows that and will likely do it very small chunks over a long period of time so as to mitigate the impact. While there is no doubt that shedding of its assets will increase 10 year bond yields, the bigger question is – how will this impact the equity market? The key to preventing a major sell off in equities would be to avoid shocking the market with a more hawkish stance than the markets are expecting. No one wants to see a rerun of the 2013 “taper tantrum” movie, one that caused major turbulence in the overall market, especially, the bond market.
With the President hinting on replacing Fed Chair Janet Yellen, whose term expires in Feb 2018, successfully managing the Fed’s balance sheet reduction, will be an integral component of Janet Yellen’s legacy. Will She or Won’t She?