The Path to New Normal

Ryan Berg

June 4th, 2018

 

 

On the evening of September 12th, 2008, the titans of finance arrived at the Federal Reserve to discuss the fate of Lehman Brothers and more importantly, the entire financial system. That following Monday, the front page of the Wall Street Journal read, “Mounting Fears Shake World Markets As Banking Giants Rush to Raise Capital.” To offset this financial collapse, the Federal Reserve, under the careful watch of Ben Bernanke, ushered in a revolutionary plan to monetary policy called Quantitative Easing (QE). This plan used the purchase of assets to provide liquidity to a struggling banking sector. At the end of it all, the Fed’s balance sheet grew from just under $1 trillion at the start of the collapse to where it stands today at over $4.5 trillion. With a strong labor market and inflation creeping above 2%, the Fed is now looking to raise interest rates and support its dual mandate. To get back to normal, the Fed also will look for options to reduce the size of its balance sheet. As we now look towards an era of growth and stability, it is unclear how large of a role the balance sheet will play in future monetary policy.

Assets

 

Given the massive size of the balance sheet, the Federal Reserve must surmise a plan that will be effective in its goal while supporting the stability of capital markets. There are two widely-considered options to complete the balance sheet normalization. The Fed may either sell securities back to the markets or decide not to reinvest the matured securities. Both possibilities could pose serious risks to stability in the marketplace if its true strength is not accurately measured. Former Federal Reserve Chairman, Janet Yellen, said she was hopeful that reverse QE would be “dull as watching paint dry.” Given the scale of the balance sheet, this will unlikely be the case.

Source: Financial Times

Source: Financial Times

Given its limited options, the Federal Reserve has decided that the best plan of action is to choose not to reinvest the maturing securities. For some investors, this non-reinvestment strategy is a major cause for concern. They foresee yield curves spiking to irrational levels as one of the largest buyers of bonds leaves the market. In response, the Fed has maintained a close watch on this issue and seeks to measure the strength of the economy on a month-to-month basis. In their last quarterly report, The Federal Reserve explained that they reinvested some of the maturing securities to the tune of $6 billion. However, they have also self-imposed a threshold limit of $12 billion per calendar month. The scale of reinvestment is an acknowledgment of bond market’s strength, and the Fed itself believes there will be a decreased need for reinvestment as the market strengthens.

 

The reinvestment into securities is a strategy employed by the Fed to keep tabs on and maintain stability within the bond market. Many investors who have feared that the largest bond investor may begin to stir the market, support this activist approach to divestment. All in all, the Fed continues to be an active player in the market as it plans to reduce its exposure and balance sheet.

 

Fed

The Federal Reserve was the first central bank to announce large-scale asset purchasing plans and is also the first in line to unwind these assets. As many central banks look towards reversing QE, they will look towards the effectiveness of strategies employed by the Federal Reserve. It is truly uncharted territory for any Central bank, which is why the Federal Reserve expects bumps in the road and has stated that it is prepared to slow balance sheet reduction or even reverse it if necessary. The speed in which they divest is expected to be gradual as the Fed gauges market reaction to liquidity reduction but is expected to pick up in pace if the market shows signs of strength. With that being said, as the Fed looks to increase its balance sheet wind down many other Central Banks will begin the QE-reversion process. This simultaneous reduction of balance sheets may lead to significant illiquidity and has the potential to result in considerable instability for the market.

While on its own the Fed’s reverse QE does not pose a significant risk, instead it will prove an important case study for many investors and Central Bank policymakers. As a leader for many Central Banks, its strategy, if successful, is likely to be imitated. However, the simultaneous reduction of balance sheets will be watched closely by investors as it may unearth major instability and liquidity shocks for the markets in the future. At a time when many government officials and free market capitalists speak out against the size of Central Banks, one thing that is certain is that they are here to stay. Whether QE will usher in a new wave of federal policy will be answered in the coming years as markets continue to be overseen by watchful Central Banks.

Disclosure:

Investing involves risk, including possible loss of principal. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Opinions reflect the market conditions when written.