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Long after the days of economic analysis based on the size of Alan Greenspan’s briefcase, it’s still a compelling question for market watchers: what will the Federal Reserve do next? Will it raise interest rates? A week ago at their quarterly press conference, the answer was “not yet”.
While the “not yet” answer is nothing new and most market participants were expecting it, this quarter’s announcement that the fed would start shrinking its balance sheet was something new. The Fed’s balance sheet? Did you even know they had one? And why does it matter anyway? The answer is quantitative easing or QE.
What is quantitative easing?
A typical Fed response to a recession or other shock to the economy is to lower interest rates (done so by lowering the target range of the Federal Funds Rate). When lowering rates isn’t enough, or when rates are already at zero as they were in December 2008, what is left for the Fed to do? Quantitative easing or QE. QE is the process whereby the Fed purchases securities from banks and other investors. These purchases create liquidity (think cash) for the selling banks and investors and also lowers the interest rates on other related securities in the market – the Fed buying drives up the price of the securities which drives down their yield. The intended result is that banks have more liquid cash to meet deposit outflows (a run on the bank), a greater ability to lend to borrowers (who themselves were in need of cash to meet their obligations) and market interest rates decline so as to spur more lending and borrowing activity in the market generally.
The Fed’s purchases through the QE program were huge, amounting to a total of $3.5 trillion between the end of 2007 and December 2014. That is a lot of liquidity. So where did all of these purchased securities go? On the Fed’s balance sheet. Yes, “balance sheet”, like the balance sheet of a large corporation or the corner gas station. So after all of these purchases, the Fed had a huge balance sheet (you can view it here ). The more the QE, the larger the balance sheet.
In 2014, as the market stabilized and the economy began to recover, the Fed stopped buying securities from banks and other investors. However, they continued to roll-over (reinvest) the securities that they held but never sold any of their investments on the balance sheet. From a market perspective, rolling over maturing securities had a moderately stimulative effect but not as much as purchasing additional securities. Fast forward to last week’s FOMC meeting and the announcement that the fed will begin selling its securities holdings and reducing (or unwinding as the cool kids say) its balance sheet. What does this mean? Its means the opposite of QE. Now the fed will be huge sellers of securities and when the supply of anything rises, the price falls. When the prices of securities fall what happens to the yield: it goes up. Also banks and other lenders may use their money to purchase the securities that fed is selling rather than making loans which could tighten up the lending market causing further increases in interest rates.
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The numbers at play here are historic: currently the Fed holds about $4.5 trillion (yes “trillion” as in one thousand billion) on its balance sheet. That is a lot of stimulation to reverse. Now the Fed isn’t going to dump all of these securities on the market at once and they have indicated that they will proceed slowly and they could always decide to stop selling at any time due to market and economic conditions. Next month, the Fed will begin to sell by letting $6 billion of government bonds mature per month and reinvesting anything above that level. But that rate will rise in increments of $6 billion every three months until it hits $30 billion per month. The same process is in place for mortgage-backed securities, which will begin at $4 billion per month, rising incrementally to $20 billion per month.
It’s time to buckle your seatbelt
The expected impact on the Fed’s balance sheet is clear: it’s going to shrink. The impact on the markets is less clear but weighted towards a negative outcome in my opinion. As the end of 2017 comes into view, the stock market is riding one of the longest bull markets in history, real estate markets are at or past their 2007 peaks and debt is building in the consumer sector. On top of this, the Fed is already in a tightening cycle . Even if the Fed had no plans to sell securities into the market, I would say that the risks to equities and other traditional investments are rising. Adding the reversal of QE to the equation only increases in the risks in my opinion.
So how can you set up your client’s portfolio for a potential bumpy ride ahead?
One approach is to seek out alternative investments that are non-correlated with the traditional financial market of stocks, bond, real estate, currencies and commodities. This will give your clients some downside protection in the event of a broad sell of in one or more of these markets. (Learn more about the importance of correlation in last month’s blog post, Correlation: The Investing Strategy You Can Use to Help Keep Your Clients’ Portfolios Safe in Troubled Times .) While I don’t think timing the market is a good investment strategy for most investors, I do think it’s wise to take a big picture look at how the reversal of QE in combination with the current market conditions could affect your client’s portfolios. And even if the reversal of QE does not cause a wide market disruption, owning non-correlated investments is always a good idea.