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As the Fed moves toward a more restrictive monetary policy, investors should consider the potential impact on capital markets.

Economy and capital markets

Fed Set to Trim Its Supersized Balance Sheet, Market Reaction Not Clear

  • Derek Hicks
  • 9/12/2017

It is probably safe to say that liquidity injection by central banks, or rather its removal, has become one of the most discussed topics in the financial community. A Federal Reserve (Fed) statement, released in June via the Federal Open Market Committee (FOMC), referred to this plan as “balance sheet normalization.”

The market is expecting the balance sheet reduction — a feat never before attempted at these massive levels — to begin in either September or October.

Simply put, it signals the end of extremely accommodative monetary policy and the beginning of a more restrictive policy. Balance sheet normalization could also be called quantitative tightening (QT), the opposite of quantitative easing (QE), which the Fed had in place from 2008 to 2014.

As talk of Fed action increases, it is helpful to demystify some of the financial terminology used in explaining the inner workings of the Fed, to summarize the unconventional path travelled so far, and to review the range of outcomes going forward.

Balance sheet normalization

In 2008, amidst the worse financial crisis since the 1930s, the United States housing market experienced a dramatic downturn. As a result, many major global banks and finance companies that held housing-related assets on their balance sheets were found to be insolvent. In other words, the book value of their liabilities was greater than their assets, resulting in negative equity.

In order to buy time for financial institutions to regain liquidity and solvency, to stabilize the global financial system, and to stimulate economic and employment activity, the Fed reduced the federal funds policy rate to a range from 0.0 percent to 0.25 percent. It remained at these levels until December 2015. In addition, the Fed took the unprecedented step of targeting mid- to long-term interest rates by instituting a program called quantitative easing. QE is a process that involves the Fed creating U.S. dollar currency notes and using this newly minted cash to purchase U.S. Treasuries and mortgage-backed securities (MBS).

This additional source of demand translated into more buyers than sellers, thus increasing the price of the securities. When the price of the securities rose, the interest rate declined. Consequently, QT will increase supply, possibly translating to more sellers than buyers. When the price of these securities falls, the interest rate increases, thereby removing stimulus and making borrowing more expensive and difficult.

Why reduce the Fed balance sheet now?

That brings us to the present question: why is the Fed tightening? Before we answer, it is helpful to recall the Fed’s mandate. It originated in the Federal Reserve Reform Act of 1977, which identified “the goals of maximum employment, stable prices, and moderate long-term interest rates.” Ironically, these goals have come to be known as the Fed’s dual mandate, despite the fact there are actually three goals.

While FOMC members stoically claim that the balance sheet reduction will be orderly and that it is not expected to have an impact on financial market stability, you have to wonder where this assurance originates.

One possible answer to the question of “why now” is in the June minutes of the FOMC, which notified us that policymakers were concerned over investor complacency and excessively high valuations in various asset classes. The minutes also shed light on the potential timing of tightening, noting the Fed will start reducing the size of its bond portfolio “relatively soon.”

According to Richard Fisher, former Dallas Federal Reserve president, the Federal Reserve has deliberately communicated the plan to perhaps begin reducing the balance sheet in September.

The projected path forward

After years of implementing these quantitative easing policies (QE1, QE2, QE3, operation twist, forward guidance), the Federal Reserve balance sheet rose to $4.5 trillion (see chart: Federal Reserve Balance Sheet). Now the Federal Reserve plans to reverse the buying process and begin selling Treasuries and MBS, per FOMC guidelines: “Treasury securities will be reduced $6 billion per month initially and the reduction rate will increase in steps of $6 billion at three-month intervals over 12 months until reaching $30 billion per month; MBS will be reduced $4 billion per month initially and the reduction rate will increase in steps of $4 billion at three-month intervals over 12 months until reaching $20 billion per month.”

Federal Reserve Balance Sheet

While the Fed may start QT in September, the collective balance sheets of central banks around the world are still growing for now. Dislocations and uncertainty risk are more likely when we see net global QT, thus the bigger market impact may arrive when the European Central Bank, Bank of Japan, and other central banks decide to start QT. That could be toward the end of the fourth quarter or later.

Market impact is uncertain

The market is expecting the balance sheet reduction — a feat never before attempted at these massive levels — to begin in either September or October. Percentage-wise, the Federal Reserve increased its balance sheet dramatically in the 1930s, then left it there. Eventually, the balance sheet became relatively small again as the economy grew. With no historical precedent available, the expected outcomes are difficult to ascertain.

We must accept the wide variability of possible market reactions and balance investments accordingly.

While FOMC members stoically claim that the balance sheet reduction will be orderly and that it is not expected to have an impact on financial market stability, you have to wonder where this assurance originates. We have ventured far down an untraveled path, but even if we had been in this position before, it would be virtually impossible to predict the outcomes (see chart: The S &P 500 and Federal Reserve Intervention). We must accept the wide variability of possible market reactions and balance investments accordingly. Diversifying beyond traditional stock and bond portfolios is necessary to manage risk and position according to probabilities.

The S and P 500 Federal Reserve Intervention

Adjusting your investment positioning

Among the potential strategies available are private investments across the risk/return spectrum: directly-owned real estate, distressed debt and other private credit, and private equity. Cash is the forgotten and largely overlooked asset class since short-term interest rates were driven to zero or even negative. With short-term rates rising, the relative value of cash reserve strategies is once again becoming relevant. Cash management can deliver return, in addition to providing stability and capital preservation.

Diversification across investment philosophy or strategy will also be necessary as passive (indexed) investing has gained popularity. Technology has provided truly uncorrelated investment strategies traditionally available only to institutional investors. These alternatives are becoming increasingly scalable to individual investors, and should be considered as another viable asset class in a rising rate environment where stocks and bonds may struggle to provide returns to which investors have become accustomed.

  • Derek Hicks
  • Director, Senior Wealth Advisor
  • CLA Minneapolis
  • CliftonLarsonAllen Wealth Advisors, LLC