Fed tactics

Investment Analysis Clubs Macro Economic Trends and Risks
1

The Federal Reserve has a large impact on the bond markets, but also impacts the stock market.

The Fed has already announced that they plan to tighten monetary policy in 2022. If they simply go ahead and raise the fed funds rate, the stock market will react badly, especially “growth” stocks and “zombie” companies with a lot of short-term debt that can’t cover interest payment with cash flow but are forced to “roll over” (borrow) to cover maturing debt.

The Fed committed to buying at least $120 billion a month in Treasury and mortgage securities to provide additional stimulus to the economy when Covid-19 hit in 2020. The central bank began reducing the pace of those purchases this past November. It plans to “taper” these purchases, which have underwritten an all-asset (stock, bond and property) bubble.

In addition to tapering the Fed’s outright purchases, it can also decline to replace the bonds already in its portfolio as they mature. This is called “runoff.”

The Fed’s balance sheet today consists of many more shorter-term Treasury securities than it did in the previous decade. If officials didn’t limit the potential runoff, the holdings would shrink relatively quickly — by about $3 trillion over two years.

https://www.wsj.com/articles/fed-weighs-proposals-for-eventu…

The Fed did not use assets aggressively until the 2008 financial crisis. For many years the Fed only controlled the fed funds rate and a relatively small amount of bond buying. The following chart shows how addictive free money becomes. The Fed tried to taper gently starting in 2018 but they were forced to return to buying in mid-2019, long before Covid hit.

https://fred.stlouisfed.org/series/WALCL

If the Fed actually does shrink its book by $3 trillion over 2 years the market will respond. That is a Macro risk that we all need to be aware of. They don’t necessarily have to raise interest rates (e.g. the fed funds rate) to do this, just quietly omit buying new bonds as old ones run off.
Wendy

13 Likes
2

The Fed’s balance sheet today consists of many more shorter-term Treasury securities than it did in the previous decade.

All balance sheets contain many more shorter-term treasury securities than in previous decades … because issuance of them (bills, notes) has grown, while issuance of bonds (>=10 years) has not grown nearly as fast. I’ve always thought, and continue to think, that this was a HUGE mistake. That’s because as interest rates rise (and in theory* they can only rise from here), since the average duration is much lower now, the interest expense will rise more rapidly. And since we not only finance excess current spending, but we also constantly refinance everything, AND finance all the interest due. That will lead to constant increases as rates rise.

  • I say “in theory” because this may be the reason rates can’t really rise. Perhaps “ever” again.
1 Like