Do you remember that massive plunging sound a few weeks ago in the S&P 500? That was just the Fed beginning to dump its $4 Trillion balance sheet.
The market didn’t like it. But again, investors don’t like anything that hints of further rate hike increases.
After all, it only took nearly a decade for the Fed to accumulate all of its holdings in an effort to prop up the US economy after the 2008 financial crisis.
And as the shrinking is set to “autopilot,” you should also note that it has been accelerated to the tune of $50 billion per month. That’s a record amount of money leaving the system.
Many investors, finance experts, and economists call this move overly aggressive.
They all say that the shrinkage is being implemented at a pace that threatens financial stability.
And they’re right. Perhaps it’s what the market needs. But in the short to intermediate term, it’s not necessarily a good thing for the individual investor…or banks for that matter.
As cited in a Bloomberg report, “the U.S. banking system could be facing a problem of not having enough cash”:
post-crisis rules enacted to curb risk-taking, like Dodd-Frank and Basel III, have prompted banks to use much of those same reserves — upwards of $2 trillion worth — to meet the more stringent requirements. It’s those forces that are, in effect, creating the scarcity of reserves that has banks — mainly the smaller ones at this point — scrambling for short-term dollar funding.
For those of you who might be confused (and we don’t blame you) let’s go over a few basics:
The Fed balance sheet reduction is the opposite of quantitative easing (QE).
During the last decade of QE, the Fed bought bonds, thus increasing the Fed’s balance sheet.
Think of this like your cash versus your house. Both cash and a house are assets, but you gave away your cash asset (less cash) but your personal “balance sheet” now includes the house asset.
Well, the Fed is doing the same thing. They bought bonds and other securities (giving cash asset away) and their balance sheet was filled with bond and other assets.
But because of the scale of their purchase, they pumped a lot of cash/money into the financial system (aka – increasing money supply). When there is more supply (in this case, money), the price (in this case, interest rate, or the cost of borrowing money) decreases.
This was how interest rates fell during the crisis. In recent years, however, the Fed’s strategy has been to do the opposite – “unwind” the balance sheet, which is the opposite of the above, leading to higher interest rates. This is why “reducing the balance sheet” is synonymous with rate increases.
Why do stock investors care? Higher bond interest rates make bonds more attractive than stocks, implying that stocks might drop relative to bonds; but more important, investors are afraid that the higher interest rates could slow economic growth (i.e. higher interest rates slow housing purchases or lead to lower corporate investments in expensive equipment).
Just like a stock price reflects expected future fundamentals, the bond prices and interest rate reflect the biggest/main fundamental driver – Fed action (raising govt rates). Right now the market is supposedly priced in one (or less) fed hikes in 2019. So when Powell indicated that there might be two (or more), the markets reacted negatively
As for the current unwinding: If you have no context of what this move means–rapidly unwinding a $4.5 Trillion balance sheet at the current rate of speed–realize that no central bank has ever attempted do something this bold before.
So What Does This Mean for You, the Average Investor?
- A Fed Reset for a Looming Recession: First, ask yourself, why is the Fed unwinding at such a rapid pace? One reason is that the Fed needs to give itself “quantitative easing” options for the next financial crisis. If interest rates remain close to zero, and if the Fed’s holdings are already massive, then the Fed won’t have any tools to help “prop up the economy” when another recession strikes.
- Rising Mortgage Rates: we’re seeing that already. As the Fed continues to dump billions in longer-term Treasuries, expect yields to rise even more.
- Extreme Financial Turbulence: We are certainly seeing this now. If you enjoyed the quiet markets of 2017, those days are long gone. As the financial markets digest every statement and every unwinding that the Fed initiates, be ready for violent swings up and violent swings down.
- Slow Economic Growth: we just experienced the largest bull market in history and the second largest economic expansion since World War II. Now that the Fed has reversed course, it may be over, if not now, then very soon. The current business cycle will end in a recession.
So what does this ultimately mean for your portfolio? It means that a storm is coming, and its time to hedge.
Don’t be overweight any one asset class, particularly stocks. But don’t be overweight bonds either as you’ll miss out on the growth potential that other assets (like stocks) can give you.
Certainly don’t exit the markets 100% and go to cash, as you’ll miss out on fixed-income and growth opportunities, and the purchasing power protection that you can receive from certain assets such as physical precious metals.
Contact our specialists at GSI Exchange to learn how to build your own “all weather” portfolio using multiple asset classes including physical gold and silver. Download our Definitive Guide to Investing in Precious Metals free of charge by Clicking Here.