After nine long years of Federal Reserve policies dominating the economic and investing landscape, it's understandable if many readers are experiencing acute "Fed fatigue" and have largely tuned out news relating to it. The economy has been muddling along reasonably well for years now, and prices of financial assets are booming, so it seems reasonable that the Fed's role in directing the economy and markets has diminished.
That view is seemingly backed by the fact that the Fed has now raised short-term interest rates four times in the past 18 months, and the economy and markets have mostly stayed on track.
However, a new wrinkle emerged last week as the Fed provided some detail regarding their plan to finally begin shrinking its $4.5 trillion balance sheet. You'll recall that the Fed built up this massive balance sheet during its Quantitative Easing programs earlier this decade. Basically, each time the Fed bought a bond as part of its QE program, it created new money that went into the bond seller's account, expanding the money supply (and in theory, giving the economy a boost as that money could be lent, spent, etc.). The bond went onto the Fed's balance sheet. As those bonds matured, the Fed reinvested the proceeds in new bonds. The initial purchases account for how its balance sheet got so huge, and the reinvestment aspect is why it has stayed so huge all these years later.
The details of the Fed's plan to begin winding-down its balance sheet are as follows. At some point in the near future (this year), they are going to gradually stop reinvesting some of the proceeds of the maturing bonds on its balance sheet. Initially, the Fed will allow $10 billion each month to be "retired," rather than reinvested. The plan is for this to expand by an additional $10 billion every three months until they reach the point where $50 billion is being "retired" each month.
This is long overdue and arguably should have been started long ago (like 2013). So it's a good thing that it's happening. Less intervention by the Fed is almost always a good thing, particularly given that there's precious little evidence that its intervention has actually aided the U.S. economy.
But just as these bond purchases injected liquidity into the U.S. economy when they were made, so will these new steps take money out of the system as these maturing bonds are retired without their proceeds being reinvested. It's a boost on the way in, but then it's a drag on the way out.
Remember, all of this is "extra" or "new" Fed policy that was put into practice for the first time following the Great Recession in 2008. Normally, adjusting the Fed Funds interest rate has been the normal accelerator/brake that the Fed has used to try to influence the speed of the U.S. economy.
So what this means is that in addition to the typical pumping of the economic brakes that the Fed has begun by raising short-term interest rates from 0% to 1-1.25%, the Fed is now taking the additional step of finally reversing the economic support provided by its QE policies.
It's an interesting case of timing, given that the economic data in recent months has been less than robust. Over the past 12 months, inflation (core CPI) fell to 1.7% from 1.9%, though Fed Chair Yellen made a specific point of trying to explain why that was just a blip due to non-repeating short-term factors. Still, those figures are below the Fed's 2% inflation target. Others aren't so sure these soft economic readings are temporary, particularly in light of reduced GDP expectations, a slowdown in housing starts, and some weakness in recent employment numbers. Perhaps not surprisingly, the Consumer Sentiment Index has dropped significantly this month.
The longer-term bond market certainly isn't buying the "growth and inflation are heading higher" story that the Fed is using as its rationale for continuing to raise rates. The 10-year Treasury yield actually fell last week after the Fed's rate hike. While the Fed controls short-term interest rates, the market sets longer-term rates, and recently the yield curve — the difference between short and longer-term rates — has been flattening. That's typical of slower growth, and should that curve invert and short-term yields actually go higher than long-term rates, that would be a classic recession indicator.
While conspiracy theorists might argue that the Fed is out to get this president, I don't honestly believe that's the case. I do think the Fed probably cares less about sparking a downturn in asset prices now that Trump is in office, knowing that an eager press will be quick to lay any blame at his feet. But I don't think they're trying to orchestrate a recession or a stock correction.
Instead, I think the Fed realizes (and has for some time) that it's way behind the curve in terms of where interest rates are and where the economy/markets are in their respective cycles. Analysis done by Gene Epstein of Barron's (as well as numerous other people) indicates that the Fed Funds rate would historically have been 2-3% higher than it is today given similar employment/inflation figures in the past.
Given that the market and the economy seem to have absorbed the past three rate hikes without any significant damage, we should expect that the Fed will continue to press their normalization plan forward. As they should — there's no reason for interest rates to be so low or for the Fed balance sheet to be so bloated nine years into an economic recovery, no matter how anemic that recovery has been.
Unfortunately, the Fed's track record in engineering "soft landings" to past market cycles has been horrible. Ultimately, the Fed's tightening produced both the dot-com crash in 2000-2002 and the Financial Crisis in 2008. In both cases, markets continued to rise as rates rose initially. But eventually, the markets reacted violently.
Long-time readers of SMI know that we've been watching monetary policy (the Fed's impact on interest rates and the money supply) as THE key risk factor that is likely to ultimately bring about the end of this bull market. So when the Fed started hiking interest rates, our antennae started quivering. Last week's announcement of the plan to shrink their balance sheet, while appropriate, is just another domino falling in that regard.
That still doesn't give us anything tangible to work with from a timing standpoint. This process could unfold quickly or slowly. As has been the case since 2008, the lack of historical precedent for the Fed's recent actions makes it pointless to try to guess what kind of timeline is likely. In addition, the Fed isn't the only Central Bank in play, and the other big ones (Europe and Japan) are both continuing their significant interventionalist policies, with the Bank of Japan going as far as directly buying stocks. These policies continue to support global financial markets.
That said, as you see the likely prerequisites for an event being checked off one by one, it should start to heighten your anticipation and preparation for that event. Preparing for the next market downturn is no different. If you haven't thought through your plan/approach for the next bear market, it's certainly time to do so.