The Federal Open Market Committee (F.O.M.C.) meets this week (Sept. 19 – 20) and will likely signal it will begin to shrink the size of the Fed’s balance sheet. It will do so by reversing the results of quantitative easing using what many call quantitative tightening (Q.T.).
Recent Financial Conditions Eased
Surprisingly perhaps, despite the three Fed funds rate increases, financial conditions eased. The roughly 10% decline in the trade weighted value of the U.S. dollar this year contributed to that easing. An additional sign financial conditions remain easy shows up in the strength of the equity markets.
Q.E. – A New World
Our mid-August commentary provided some background on the shift to a more normalized monetary policy. Before the financial crisis, the Fed’s balance sheet totaled less than $1 trillion and contained no long-term Treasury debt or agency paper. Currently, the balance sheet totals nearly $4.5 trillion including $2.3 trillion of U.S. Treasury notes/bonds and nearly $1.78 trillion of agency mortgage-backed securities. For further perspective, the Fed holds nearly one-third of all the outstanding M.B.S.
Q.T. Limited History to Base Forecasts
With the Fed never holding Treasury notes/bonds and agency paper before the financial crisis, the F.O.M.C. is embarking on a new path as it shrinks the Fed’s balance sheet. With no historical experience, the impact of Q.T. will likely provide some surprises.
How to Shrink
The F.O.M.C. indicated that it would shrink The Fed’s balance sheet by decreasing its reinvestments in maturing treasuries and M.B.S. By the end of the first year, the F.O.M.C. will shrink the balance sheet by $30 billion of Treasurys and $20 billion of M.B.S. each month.
Absorbing the Shrink
With the Fed reducing its purchases of Treasury notes/bonds and M.B.S., those markets will depend increasingly on private investors to absorb the slack. Adding to their burden, the increasing Federal deficit will add further to the supply of Treasury debt. Economists expect this gradual shift to greater dependence on private buyers to result in just a modest upside move in long-term interest rates. Most economists seem to be forecasting a 25-50 basis point increase in 10 year note rates once the Fed finishes shrinking its balance sheet. The obvious caveat, no history exists to base these forecasts.
How Far Will the Balance Sheet Shrink?
How far the F.O.M.C. will shrink the Fed’s balance sheet will depend, in part, on what system it will use to manage the Fed funds rate. Without getting into the details, the choices will be either its current “floor” system or the “corridor” system used prior to the financial crisis. As a note, before the financial crisis, most economics students in college learned the “corridor” system in their baby economics course.
Most economists seem to expect the Fed will likely stick with the current “floor” system. If that proves the case, the Fed’s balance sheet will likely shrink to about $3 trillion. That level still represents a major increase from pre-financial crisis levels of less than $1 trillion dollars. The F.O.M.C. will then likely increase its holdings again as the economy grows.
The Return of Quantitative Easing
The F.O.M.C. will need to return to quantitative easing in the future to fight recessionary forces. In the current environment, some economists expect the F.O.M.C. to increase the Fed funds rate to about 3%. For perspective, a recent Goldman Sachs research study pointed out that the F.O.M.C. cut the Fed funds rate over 5 percentage points in the average post-war recession. Assuming the F.O.M.C. will not move to a negative rate policy, the expected peak in the Fed funds rate leaves the committee little choice but to re-implement quantitative easing to deal with recessionary forces.
Quantitative tightening may eventually lead to greater credit selectivity in the high yield markets. If this proves correct, the overall high yield market may prove to be vulnerable. Then many corporations with weak financial positions may lose their easy access to credit market financing. Investors may see so called zombie corporations disappear. The resulting outcome would likely bring industrial consolidation around more efficient corporations and improved productivity for the overall economy. Investors need to be particularly watchful of businesses with weak financial balances sheets and cash flows.
With Q.T. likely causing higher interest rates at the long end of the yield curve, interest sensitive equities such as housing and housing related stocks will likely prove vulnerable. The same warning applies to bond like equities such as utilities and REITs. Instead, income oriented investors should consider equities with demonstrated earnings and dividend growth. Simply using high dividend yields as a basis for building income portfolios should only be on a limited basis – if then.
Investors should also expect the possibility of greater volatility in the financial markets from Q.T.—or just the opposite of what financial markets experienced with quantitative easing. The old market constant, in our opinion, still applies: “do not fight the Fed.” This decade proved that advice to be correct.
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