Morning Market Thoughts
Good morning. The market opened flat again today. Simply put, volatility is virtually nonexistent, and it is a very very slow news day.Just a couple of thoughts about the FOMC meeting later this month:
Later this month the Fed is likely to hike rates. Expect the typical banter and ginned up suspense by the financial pundits. A quick google search will yield a lot of conflicting cross talk among Fed presidents. Dallas Fed President Robert Kaplan recently said that he thinks the FOMC should raise rates twice this year, and start to unwind the Fed’s $4.5 trillion balance sheet. But then, don’t forget about James Bullard, another Fed president who changes direction more than a falling leaf on a windy day. He fears that the Fed is going to hike rates too quickly. So basically, it’s a mixed bag in the FOMC when it comes to hiking rates.
But the big deal is the unwinding of a $4.5 trillion balance sheet.
Here’s how they do that: Over the past 9 years, the Fed began buying tons of US treasuries (and other assets such as mortgage-backed securities, which are beyond the scope of this note). They did this to keep rates artificially low. The result? Free money! While a lender (such as a bond buyer) used to be able to get a return on their money, the quantitative easing program made that impossible. Why should you get paid for lending your money when the borrower could basically get it for free? Interest rates were so low that borrowing had virtually no cost — other than the requirement that you pay back the loan. So investors with money had to search elsewhere to find a decent return on their money. The result? A bull market in equities that continues to reward investors.
Back in 2014, the Fed ended its bond buying program. The announcement was made on October 29th. (At that time, the Fed’s balance sheet was a whopping $4.5 trillion bucks). This type of thing is rarely a surprise. The market began factoring this change in Fed activity a few weeks earlier. The S&P fell more than 6%. By the time of the announcement, the market was already in rally mode, and the bull market continued unabated.
While the Fed stopped buying bonds in 2014, their balance sheet was stuffed with all the bonds they had bought between 2008 and 2014. As those bonds matured, the Fed would reinvest the proceeds back into the market. So while their balance sheet wasn’t getting bigger, it wasn’t shrinking either. It has been static, remaining at $4.5, all with varying maturity rates.
The Fed is expected to announce that they’ll only be reinvesting a portion of the proceeds they receive from maturing securities. Over time, the balance sheet shrinks.
This is a good thing…unless it’s not. If the Fed unwinds the balance sheet too quickly the impact on the market could be significant. I really don’t see this happening because the Fed is about as tame as tame can be. They talk a lot, but do very little. This is another good thing. So I think the unwinding will be soothing to investors as they anticipate a gradually normalizing Fed.
The reason I’m mentioning this is because you’re likely to hear a lot about this in the next few weeks. It’s really not confusing…if you understand the process.
(Don’t overtrade. This is a 4-day week, and volume is light.)
–Dan
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