Market Beat: Reducing the size of the Fed’s balance sheet
September 20, 2017
The Fed is going to start to reduce the size of its balance sheet, which is currently valued at about $4.5 trillion dollars. The balance sheet was built primarily by a process known as quantitative easing or QE. What they'll embark on now will be a process referred to as quantitative tightening.
Quantitative easing is a fairly unconventional monetary policy designed to put more cash into the economy when some stimulus is needed. The process of quantitative easing is accomplished by purchasing bonds on the open market and holding them on the balance sheet. That provides financial institutions with cash that should theoretically find its way into the economy. QE is used when interest rates are already at or near zero.
This round of QE was started during the recession of 2007-09, which followed the burst of the housing bubble. The Fed was pumping about $85 billion per month into the economy with its quantitative easing strategy through bond purchases
As the Fed starts tightening by selling off assets on its balance sheet, it will do so initially at a very slow pace. They have indicated that they will start the tightening process at a rate of about $10 billion per month. Every quarter they plan to increase the bond selling rate by another $10 billion until they hit $50 billion per month, at which point they will cease increasing the sales and hold at $50 billion monthly.
They may decide to maintain a relatively large balance sheet, and only reduce it by about $1 trillion to $2 trillion dollars — $3.7 trillion was added to the balance sheet in the years following the financial crisis.
The impact on the bond market is uncertain at this point. One likelihood is that we'll see interest rates rise gradually as the process gets underway. Hopefully, the Fed won't do anything drastic that could spook the bond market. One Fed study showed that current policy was effectively lowering bond yields by slightly over 1 percent, which means that the tightening could potentially put long-term yields in the 3 percent to 5 percent range.
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Normalized interest rates will be good for conservative investors and savers. The Fed is entering uncharted waters here with this type of monetary policy. The Fed should proceed at a slow, steady rate and not do anything dramatic. I don't expect interest rates to rise dramatically in the near term.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.