Are we over-reacting again?

by Doug Drabik, Fixed Income, Raymond James

Many questions continue to circulate about the consequences of the Fed ā€œundoingā€ its ballooned balance sheet. What will happen? The short answer is no one knows as we are in unchartered waters. The Fed has never carried such a large balance sheet and therefore has never liquidated one. The effectiveness of their action could be debated all day long. Of course this provides the latest stage for various media outlets to dramatize the potential effects of the Fed move. My only reminder will be the numerous instances the media, experts and pundits got it wrong, which typically involves some rash interest rate forecast.

The Fed used the balance sheet to keep interest rates low and the economy moving. Following the great recession of 2008, the Federal Reserve (Fed) launched a series of quantatitive easing (QE) programs intended to stimulate the economy by injecting money into the system with expectations of boosting the economy. At the very least, buying bonds in the open market helped prevent an abundance of bonds, assisted in keeping rates from rising and kept borrowing costs from escalating.

Remember that the Fed does not act like a typical bank. When purchasing bonds in the open market, they pay for them by crediting the reserve account of the member banks, in essence, creating ā€œnewā€ money. Now this is where the debates really take off. The idea is that the banks now have additional money to loan out to businesses and people who can fund new business or other economic activities. It can be argued that this didnā€™t occur as money just idled in the form of growing bank reserves. In other words, it never stimulated the chain of economic events to boost the economy to the degree that was intended.

The Fedā€™s balance sheet prior to QE was roughly $858 billion. By the end of 2009 it reached $2.24 trillion and today it hovers around $4.5 trillion. One fear is that we experience a repeat of the 2013 taper tantrum. An event where the Fed merely announced it was cutting back on its open market purchases and the market became anxious it would create unstability. Would there be enough buyers for all the bonds? Would interest rates and thus mortgagte rates rise? Would it hinder the housing market recovery? Bond yields increased dramatically but eventually leveled off once it was realized that the panic was not justified.

So have we become a panic reacting market? There are reasons the Fed may keep a larger balance sheet than it did prior to the QE programs. Among them is the increased availability of safe assets for market participants that the central bank can provide in a liquidity crisis. When liquidation does begin, the scaled reduction may be complemented with simply letting maturities roll off. There are $2.5 trillion in Treasuries of which $1.4 trillion have maturities less than five years. Again, we are in uncharted waters and no one really knows what the affects on the market will be but we can rationalize an orderly dispersal just the same. The bond market over time has been very rational and in the end may well continue to be so.


To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Associationā€™s ā€œLearn Moreā€ section ofĀ investinginbonds.com, FINRAā€™s ā€œSmart Bond Investingā€ section ofĀ finra.org, and the Municipal Securities Rulemaking Boardā€™s (MSRB) Electronic Municipal Market Access System (EMMA) ā€œEducation Centerā€ section ofĀ emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the reportā€™s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

 

Copyright Ā© Raymond James

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