Don’t Be Worried – The Fed Unwinding Balance Sheet

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At last week’s Federal Reserve meeting as expected the Fed announced that they would start unwinding their $4.5 trillion balance sheet in October. Some are worried that this will have a harmful effect on our “sugar-high” economy. This is just a subtle form of tightening – taking money out of the market. Probably nothing to be concerned about.

Here is a simple explanation of how all of this works. Since the great recession, our Fed has been buying both Treasuries and mortgage backed securities from Frannie Mae and Freddie Mac. Now they will stop buying new securities as the old ones mature and sell off some additional ones. In effect the Fed “created” the cash to buy these out of thin air in the first place, therefore a method of adding cash to the banking system. When they stop and start selling these securities, cash comes out of the system, therefore tightening. There is too much money in the system today, it needs to bleed out slowly to more normal levels.

Frannie Mae and Freddie need to sell their new securities to someone or the home mortgage market crashes. This however is not a problem as there is about $2.2 trillion sitting idle around our banking system. The nice interest rate paid by these two always draws interest, and they are 100% insured by the US Gov’t. Our Fed will probably unwind the balance sheet down to maybe $3 trillion over the next 4 years and hold steady. That’s a measly $300 billion a year. This is just part of the normalizing process. This winding down does not affect the Fed’s overnight interest rates or its slow increase.

Some Americans had been quick to panic that our Fed was holding way too much on its balance sheet in the first place, but this is not the case. So our Fed holds $4.5 trillion as the world’s largest economy, however the Peoples Bank of China hold $5.2 trillion, the European Central Bank holds $5.1 trillion and Bank of Japan holds $4.7 trillion! Considering the US is by far the world’s largest economy, by a wide margin, our % of balance sheet to GDP is way down. Furthermore, we are tightening, and they are continuing to pump more cheap money into the global system. We are in pretty good shape!

So where else will huge chunks of cash come into our economy from? The rest of the world of course. As other nations choose to either buy their national securities at negative or .5% interest rates, they can buy the US 10 year at 2.25 -2.5% yield. This is exactly what will happen, it’s often called the “carry-trade”. Borrow money at very low rates in your country like Japan and use that cash to buy US treasuries, pocketing the difference as profit. This has been going on for many years.

So, what does this mean to all of us workers and retirees? Our economy is strong based on fundamentally good corporate earnings worldwide, especially in the US. With this very slow unwinding and equally slow Fed rate increases over the next several years our GDP growth will remain equally as slow, inflation almost non-existent and overall stock market returns muted. The fixed income market will continue to be lower yielding!

 

 

 

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