The Fed begins its great bond runoff experiment … why the outcome is unknown … if the market gets into trouble, don’t look to the Fed
The Fed has just embarked on an enormous – and risky – experiment.
While interest-rate levels are getting all the attention, what’s less discussed, because its outcome is more of a mystery, is the reduction of the Fed’s balance sheet.
This is a murky issue, because we’ve never been in this exact situation before.
The hope is the Fed’s balance-sheet actions will help engineer the “soft-ish” landing that Federal Reserve Chairman Jerome Powell is trying to achieve.
The risk is these actions accidentally strangle the economy, leading to a recession.
Let’s take a closer look at what’s happening.
***After the pandemic hit, the Fed doubled the size of its balance sheet
Why? And what does that really mean?
Well, when the U.S. economy smashed into the wall known as Covid lockdowns, the Fed sprang into action to help prop up the economy.
It slashed interest rates and began buying government bonds and mortgage-backed securities.
Slashed rates made it easier for companies to borrow “cheaper” money in order to grow (helping the economy). Slashed rates also made it it easier for individuals to borrow this cheaper money in order to spend, while theoretically disincentivizing saving (which would also help the economy).
Bond purchases were another method employed in an effort to achieve the same goal.
The Fed began buying billions of dollars’ worth of U.S. bonds and mortgage-backed securities in order to stimulate the economy.
But then something happened that hasn’t occurred in decades…
***All of this liquidity, combined with supply-chain problems, turned into massive inflation
Econ 101 tells us that inflation happens when you have too much currency chasing after the same volume of goods.
Well, after decades of slumber, the great inflation beast awoke. That’s what happens when we flood the economy with a tsunami of dollars, while simultaneously the volume of goods available drops (again, due to supply-chain problems).
Now, a quick aside – some astute readers might wonder why we didn’t see runaway inflation after the Fed slashed rates and bought bonds in the wake of the Great Recession.
It’s complicated, but in short, it’s because most of the added liquidity didn’t actually make it into the broader economy. Instead, it went to shoring up the destroyed balance sheets of the big banks.
This meant all those dollars weren’t freely accessible for you and me to spend in the wider economy. Plus, we didn’t have the same supply-chain-based product shortages back then.
But following Covid, we were in a different world.
Trillions of dollars were mainlined into the economy and directly into bank accounts. And the scope of this monetary creation was mindboggling. In fact, it’s estimated that 23.6% of all the U.S. dollars created – ever – were created in 2020 alone. We’ve never seen so many dollars created in such a short period of time.
With the help of stimulus payments, government help programs, and a sidelined economy, the U.S. savings rates hit a record 33% as stuck-at-home Americans stockpiled their cash.
So, when the nation finally reopened, consumers were flush and ready to spend…only to find fewer goods available, thanks to supply-chain bottlenecks.
Too many dollars + too few goods = historic inflation.
Now, fast-forward to today.
***As of June 1, the Fed has begun shrinking its $8.9 trillion balance sheet as a pace of $47.5 billion per month
Specifically, the Fed is running off $30 billion of Treasuries and $17.5 billion of mortgage-backed securities each month until September. At that point, those amounts will double to a combined $95 billion.
So, what does this really do?
Well, it was too much liquidity that got us into this mess. So, the goal of this balance-sheet reduction is to begin draining this liquidity out of the system.
The Fed ending its bond-buying program turns off the dollar-spigot that’s been flooding the bond market.
While the Fed has engaged in a bond runoff campaign before (following the Great Recession), what’s different this time is the size of the runoff. The Fed’s peak runoff amount the last time around was $50 billion a month. As you just saw, come September, the Fed will basically double that amount.
So, what will happen?
No one really knows.
We’ve never done this before at this level, in this type of economic climate, with rates climbing at this pace.
Fed Governor Christopher Waller was transparent about this in a speech he gave last Monday. He said that estimates “using a variety of models and assumptions” are “highly uncertain.”
And the minutes from the Fed’s May 3-4 meeting reflect the same “who knows” shrugging:
Regarding risks related to the balance-sheet reduction, several participants noted the potential for unanticipated effects on financial market conditions.
***One potential risk of the balance-sheet runoff for stock investors is surging bond yields
Bond yields and bond prices move in inverse fashion.
Rising bond prices push down bond yields. Falling bond prices mean climbing yields.
As stock investors, we care a great deal about bond yields. After all, the higher they go, the more likely it is that some investors will sell their riskier stock holdings in exchange for the relatively safer investment of bonds that are paying higher yields. Obviously, investors selling stocks pushes down stock prices.
If we look at tech stocks this year (which are especially sensitive to higher rates and yields), we see a correlation between the worst selloffs coming in response to a surge in the 10-year Treasury yield.
So, as stock investors, we don’t want nosebleed bond yields.
But think about the effect of the Fed and its actions in the bond market…
When the Fed was buying billions of dollars’ worth of bonds, what was happening?
Well, the Fed’s purchases artificially increased the demand for bonds. Increased demand leads to higher prices, which pushes yields lower.
But now that this artificial demand is ending, what’s going to happen?
Again, we don’t know for sure, but here’s MarketWatch:
As the Fed stops supporting markets with asset purchases and instead leaves more supply for the private sector to absorb, the upward pressure on interest rates could intensify.
Already mortgage rates are rising as the Fed hikes rates and as longer-term rates rise…
It would be a big enough challenge for the Fed simply to be trying to make a reduction in its balance sheet. But, in fact, it is doing it under duress and with the need to hike rates and slow galloping inflation.
All of this puts a great burden on the Fed to get things right — to try to get too many things right, at exactly the right time.
I’ll just add that, as I write Monday morning, the 10-year Treasury yield is back above 3%.
***What happened the last time the Fed engaged in a balance-sheet runoff?
Though we can’t attribute what happened specifically to a balance-sheet runoff, in 2018, the result of the Fed’s runoff plus interest-rate hikes resulted in a 20% stock market crash heading into that Christmas.
From Chief Investment Officer, highlighting what happened that time:
Reducing the central bank’s bond holdings has “only happened one other time, and the Fed didn’t get too far before having to reverse course,” LPL Financial’s fixed-income strategist, Lawrence Gillum, has observed. “This time will go more smoothly.”
It will? Why? Where’s the evidence for that?
As we highlighted above, we’ve never been in this scenario before.
We have historic inflation that wasn’t here in 2018, the Fed is hiking in 50-basis-point increments that it wasn’t doing in 2018, we have product shortages from supply chains that weren’t here in 2018, there’s a war in Europe that wasn’t here in 2018, the broader economic backdrop is different than 2018…
Here’s how Bloomberg is sizing up these challenges:
…The Fed also faces an economy coming out of a recession of only a year ago with fiscal excesses, with lingering supply chain issues, with a dislocated work force that has been scared by Covid, and with oil prices that are still swirling to higher levels as OPEC policy, the Russia-Ukraine war, and the president’s insistence to push his green agenda, place more challenges on top on an economy already maxed out with challenges.
This is not just a perfect storm. This is a perfect storm coinciding with a mega hurricane and the quintessential earthquake/tsunami all at once.
***Now, consider what else is different this time around – namely, the Fed appears far less concerned about how its actions might impact the stock market.
Here’s Bloomberg, commenting on the significance of Powell saying he wants tighter financial conditions:
The comments amount to Powell effectively endorsing a selloff in US equities that took the S&P 500 to the edge of a bear market (a 20% decline from the high) [back in May] …
For anyone who invests in stocks and bonds, these comments effectively amount to Powell saying that the famous “Fed put” is gone. In other words, the central bank won’t save markets by altering to an easier policy stance.
Kansas City Fed President Esther George was rather direct about her disregard for Fed policy on stocks:
I think what we’re looking for is the transmission of our policy through market’s understanding, and that tightening should be expected.
So, it’s not aimed at the equity markets in particular, but I think it is one of the avenues through which tighter financial conditions will emerge.
Translation – “we’re fine with stock-market pain because that will help tighten overall conditions.”
***We’re beginning to run long, so let’s wrap up
Most likely, we won’t get our first clues about the impact of this balance-sheet runoff until later in the year.
The impact of tighter conditions will take time to work through the economy. Plus, we won’t even hit the combined $95 billion runoff pace until September.
But recognize what this is…
That doesn’t mean we’re destined for a recession and stock-market meltdown. But it does suggest some caution isn’t a bad idea until we get a sense of the outcome of this grand experiment.
We’ll keep you updated.
Have a good evening,
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