The Fed’s $4.5 Trillion Dilemma
As you may have heard or read, the Federal Reserve is set to unwind its massive $4.5 trillion balance sheet. Understandably, it’s probably not the topic du jour at the family dinner table. Yet, it is a highly significant, and potentially problematic event for the financial markets. So, what exactly is going on, and why is this so important?
First, some history. From December 2007 to June 2009, the U.S. had fallen into a recession, caused by the housing bubble and subsequent subprime mortgage crisis. To help boost a flailing economy, the Fed dropped the benchmark fed funds rate to near zero, which short-term debt is often based on. The hope was that lower credit card and bank loan rates would spur consumer spending and economic growth.
Despite the Fed’s efforts, the economy continued to decline while unemployment soared. Unable to lower the benchmark rate further, the Fed turned to Quantitative Easing, or QE.
Briefly, QE is when a central bank, in this case the Fed, purchases long-term government debt or securities. The effect is to increase the money supply while driving down long-term interest rates. The Fed hopes that flooding the market with cash, combined with lowering long-term interest rates, will artificially create demand for goods and services, thus stimulating economic growth.
The QE program serves as the best example of the industry reference “printing money.” From November 2008 through October 2014 the Fed purchased a hefty $2.4 trillion of government debt and securities. This balance now stands at a colossal $4.5 trillion, or about a quarter of America’s annual gross domestic product - the total dollar value of goods and services produced by the U.S.
The Fed has stated that it will begin to unwind this immense balance later this year. But why start now, almost three years after the QE program ended? Until recently, the economy has not been deemed strong enough to withstand the stresses of the unwinding process. Also, the Fed is now concerned that the sheer mass and size of the balance sheet may be causing distortions in the financial markets. With interest rates and bond yields driven so low, the QE program inherently prompts investors to take greater risks, such as investing in the stock market, in search of higher returns. And the Fed is increasingly concerned with the excessive valuations currently imbedded in stocks.
But this begs the question, how can you unwind an unprecedented $4.5 trillion in bonds and securities and not disrupt something? The short answer – very carefully.
The Fed realizes it cannot abruptly sell off its entire balance sheet. The resulting impact to the financial markets would be catastrophic. In fact, it won’t sell anything. It will simply stop reinvesting the proceeds from maturing bonds and securities into new purchases, letting the assets roll off its balance sheet. The reduction will be gradual and in scheduled increments. This should give the Fed flexibility to respond to any reaction by the financial markets and allow the effects to be absorbed with minimal impact.
However, the unwinding of the Fed’s balance sheet is not without risk, and the effects on the financial markets can be significant. As designed, the QE program serves to artificially keep bond prices high and bond yields low. This inverse relationship between bond prices and yields means risk of plummeting bond prices and soaring interest rates as the Fed sheds its holdings. Even if the reduction is done at a slow and predictable pace, it will still increase the cost of long-term debt, impacting consumers and businesses on everything from mortgages to bank loans and long-term financing of equipment.
As the Fed looks to avoid potential market volatility in reducing its assets, the process will certainly have a constrictive effect on the economy. The expected third rate hike in December could add further pressures to consumer and business spending. The Fed has vowed prudence and caution in this endeavor, but nonetheless, there are tremendous risks and pitfalls. Already faced with a lackluster economy, low inflation and stagnant wage growth, let’s hope the Fed is up for the task.
Mark M. Grywacheski, Investment Advisor
Opinions expressed herein are subject to change without notice. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any securities at any given price. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets, or developments mentioned.
Quad Cities Investment Group, LLC is a registered investment advisor with the U.S. Securities Exchange Commission.
