The Federal Reserve Bank currently has a balance sheet valued at $4.5 trillion. That represents an extensive holding of assets, and the Fed has made it clear that it wants to wind down. As we move towards the vaunted June 14, 2017 meeting of the Fed FOMC, it’s important to take stock of where the Fed is headed, and how that will affect markets.
Since the 2008/2009 global financial crisis, the Fed has had an important role to play in the financial markets. It occupied this position by taking an active role in asset purchases, by way of its quantitative easing policies. Over the years, the Fed has amassed a multi-trillion-dollar balance sheet and it’s time for this to wind down.
In the eight years since the global financial crisis, the Fed injected liquidity into the markets. It did this by purchasing mortgage securities and Treasury Bonds on a mass scale. This was done in an effort to flood the markets with money, keep interest rates low, and encourage investment spending. It worked. The US economy is now on track with its lowest unemployment rate in years (4.4% for April) and concomitant strong growth in NFP data.
For the Fed to remove itself from financial markets, it needs to walk a fine line. Too much unwinding too quickly will destabilize the financial markets in a big way. One of the ways that the Fed is looking to extricate itself from its QE policies is quantitative tightening – interest rate hikes. On June 14, the Federal Open Market Committee (FOMC) will be meeting to discuss the federal funds rate.
Currently, the likelihood of a Fed rate hike is up at 83.1%, a considerable jump from one month ago on April 24, 2017 when the likelihood was just 63.1%. The greater the probability of a rate hike in the region of 1.00% – 1.25%, the more market players are going to factor this into their decision-making processes.
Most everything we see on the markets is speculative, and it is the actions of these traders and institutional investors (fund managers especially) that drive markets up or down. But for the Fed to adopt this policy, it needs to understand how the economy is really performing. Back in 2013, the Fed began tapering its QE policies, and the markets reacted negatively to this activity.
What is strange, given the low yields on US treasuries (notably 10-year Treasury bonds and 30-year Treasury bonds) is that the rates are low, yet they are not negative like the rates in Japan, or across Europe. The Fed has dual possibilities in the form of QE tapering, and rate hikes. By divesting assets from its balance sheet (selling assets) and tightening interest rates at the federal funds rate level, more money will be taken out of circulation.
This should theoretically improve the USD, make imports more affordable, but hurt the country’s export potential. Bank of America Merrill Lynch analyst, Mark Cabana is of the opinion that the Fed may reduce its asset holdings by as much as $1 trillion. One thing that is unmistakable is that when the Fed winds down, the yield on 10-year Treasury notes will rise.
Precisely when the Fed will adopt these policies remains uncertain. Analysts anticipate that there will be several rate hikes before the Fed starts selling assets. Soft economic data releases have delayed the divestiture efforts, but if a weakening is not on the cards, the Fed will move ahead with its plans. Presently, the consensus is that there will be 2 rate hikes – June & September. By all accounts, the selloffs are only likely to take place towards the end of 2017, perhaps early 2018.
How Does This Affect Personal Investing Opportunities?
Equities markets are currently bullish, despite fears that a market bubble is forming, or a correction is imminent. The Dow Jones, NASDAQ, S&P 500 and others are trading near-record levels and every time there is a dip, market participants buy into the dip. This is creating a degree of concern among strategic analysts who believe that elevated valuations are being created. For now, the fundamentals of US markets are sound, but too much latitude on stock prices could usher in market corrections.
As we enter into a period of interest rate tightening, it becomes especially important to objectively analyze one’s personal situation. Now may not be the most appropriate time for taking out a mortgage willy-nilly. It’s important to use the appropriate tools and resources such as a calculator to ascertain which financial institutions offer the best rates given the current economic climate.
Unfortunately, most traders do not maintain perspective on the markets – it’s not a day to day activity; it’s a long-term projection that needs to be properly evaluated. Every market goes through cyclical movements, and investors should not be deterred by occasional hiccups. There are ways to solicit proper advice, notably from financial planners who charge fees for their services – not stockbrokers or fund managers who sell investments to their clientele.