How The Federal Reserve Will Make $4 Trillion Disappear

In The News...

Nine years later, it appears the day has finally come.

The U.S. Federal Reserve will begin to reduce its balance sheet by reversing the quantitative easing (QE) stimulus measures that began in the wake of the 2008 recession. For the past decade the Fed has been buying Treasury bonds and mortgage-backed securities, which has consequently injected new money into the U.S. economy. Such liquidity actions are implemented to promote lending/borrowing between banks and consumers during periods when the economy slows.

What makes this Fed decision unique? What makes QE so unprecedented is that it has been going on for nearly a decade, to where the Federal Reserve balance sheet now holds $4.5 trillion in Treasury bonds and mortgage-backed securities. To begin the unwinding process and shrink its balance sheet to a more normal level, the Fed will let $10 billion of bonds mature and roll-off its balance sheet each month moving forward. That amount will gradually increase to the tune of $50 billion monthly.

What about interest rates? This announcement came following the latest Federal Open Market Committee (FOMC) meeting this past week. The Fed opted to hold off on interest rates, keeping its benchmark federal funds lending rate at 1.00% rather than increasing it to 1.25%. The committee expects to increase rates once more in 2018. Fed leaders meet twice more before the end of the year.

The decision to roll back QE means the Fed must feel comfortable regarding its two goals:

  1. Maximum level of employment
  2. Annual inflation growth of 2%

The first goal is open to interpretation. The official unemployment rate is 4.4%, which has improved substantially from when it peaked at 10% in late-2009. A sub-5% unemployment rate appears to be within the Fed's target range, but that is hard to tell. The second goal of 2% inflation is also within range despite the fact that the Fed itself reduced its inflation expectations over the next two years.

What do I think of the Fed's decision and what does it mean to investors? See the OPINION section below.

In The Market...

The S&P 500 was fractionally up +0.1% this past week. Let's look under the hood:

(price data via Yahoo Finance)

STOCKS: The S&P index was essentially flat, so it comes as no surprise that the sectors were nearly split between winners and losers. Interest-rate sensitive sectors were the biggest movers, which is also no surprise amid the Fed announcement. Financials were the largest gainer while the dividend-heavy Utilities and Real Estate sectors were the worst performers. This week was a net-negative for us, because despite the fact that many client accounts own Financials, all accounts own Utilities.

BONDS: The bond market followed suit, although interest rates did not rise as much as you might expect in light of the Fed news. We are still sitting on a chunk of cash in most client accounts, ready to deploy it once bond market conditions oblige.

In Our Opinion...

What does the historic unwinding of QE mean for the market and investors? Right now, not much. But let's first remind ourselves how we got here...

The Fed has two jobs: Monitor inflation and manage liquidity. Said differently, ensure that prices of goods and services do not rise too quickly or fall too sharply, while also ensuring that there is the right level of cash in the economy to promote steady lending/borrowing. The latter is precisely what QE aimed to accomplish. When the economy slows and both businesses and consumers turtle-up from spending, liquidity becomes an issue. Bond-buying programs help combat that by pumping new cash into circulation. As we have seen though, deciding when to turn that off is challenging. The Fed has taken a lot of heat for not unwinding QE sooner. To be honest, I do not know if this is the right time or whether it should have happened before now. Hopefully the market is stable enough to consume this gradual monetary tightening process.

Which brings me back to what this means to investors... The stock market has moved higher over the past year without much volatility, which is just the way we want it. This needs to continue or else the Fed could deviate from its plan. We would expect interest rates to creep higher as well as the Fed raises short-term rates and as investors prefer stocks over long-term bonds (remember, weak bond demand means falling bond values, which means rising interest rates).

But if there is one thing we know, the market is unpredictable. For years the herd mentality believed that interest rates would spike. If you turned on financial news you would hear that over and over. Let me be clear...

That simply never happened.

Yes, rates have risen over the past year. But these rate increases have been tepid and have occurred long after the time when "experts" predicted. The fact also remains that long-term interest rates will ultimately be determined by how investors react to the health of the stock and bond markets over time. If stocks fall in a sharp or prolonged manner I would bet that investors flock into Treasury bonds. This would send bond values up and interest rates down.

In Our Portfolios...

Q&A/Financial Planning...

A reminder for those of you who are self-employed! Next week is your last chance to set up a Simple IRA for 2017 if you want to contribute this year. If taxes are a concern and you are able to contribute more than the $5,500 Traditional IRA annual limit, consider setting up a Simple IRA where you can contribute $12,500 (or $15,500 if you have reached age 50).

There are other considerations though, namely the requirement to match what your employees contribute. Also, consider the long-term viability of the retirement plan and whether the parameters and restrictions of a Simple IRA align with where your business is headed in years to come. If you already have a Simple IRA plan then this deadline is moot. If you have a Simple IRA and feel you can contribute more than $12,500 for the year, consider graduating to a 401k plan. I am happy to expand on any of this, just ask.

What's New With Us?

As of Sept. 18th TD Ameritrade and Scottrade are now one, joint company. You may receive some notification on this, but no action is required. I expect that your tax forms for 2017 will be consolidated between the two custodians to ensure seamless Form 1099 tax reporting.

Have a great weekend!

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Brian E Betz®