At the January 2022 meeting of the Federal Reserve’s Federal Open Market Committee (FOMC) chairman Jerome Powell announced their “intention” to end its quantitative easing (QE) program that they launched back in March of 2020 in reaction to the Covid pandemic and its potential impact on our economy. This program was the biggest and broadest monetary-stimulus campaign in modern history. As a result of their most recent meeting the Fed is now in the process of withdrawing its support for the U.S. economy. One of the first action items in their plan is the strong likelihood of shrinking its record balance sheet of over $8.5 trillion. There are two likely maneuvers that the Fed can use in their effort to drive down today’s inflation which is currently 7.2%, the highest since 1982.
The Fed’s first plan of action started in December of last year when Powell and company reduced their monthly bond buying from $120 billion (which it initiated at the start of the 2020 Covid crisis) to $60 billion per month. Bond buying drives the price of bonds higher which helps to force interest rates down making it less expensive to access money. An action of this type helps to stimulate economic activity and usher in the prospects of an economic recovery. Since the Fed is now buying fewer bonds per month ($60 billion instead of $120 billion) it’s anticipated that they may stop their buying program all together by the end of March 2022. Bond returns will likely continue to feel the pressure, meaning it could be difficult to get decent returns especially from traditional types of bonds. As such one might assume that investors should avoid bonds all together. Our comment to that is that bonds still represent portfolio diversification and predicated on the specific type of bond an investor may own it can be a safer approach to counter stock market volatility. We should probably also add that it may be more prudent to be in shorter maturity ranges perhaps 1 to 5 years. Cash flow counts in portfolio diversification especially when the stock market is under pressure and there are many types of bonds that can still provide that benefit.
The second tactic of choice is for the Fed to reverse its current policy on interest rates and instead of keeping them at our current historical low, 0.25% (which by the way is where it was a year ago), to raise them. This is called (QT) which stands “quantitative tightening”. To better explain the Fed Funds Rate is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis. The law requires banks keep a certain percentage of their customer’s money on reserve where the banks earn no interest on it. Consequently, banks try to stay as close to the “reserve limit” as possible without going under it as banks lend money back and forth with each other to maintain the proper level. In a nutshell the fed funds rate is used to control the supply of available funds (money) hence impacting inflation and other interest rates. Raising the fed funds rate makes it more expensive to borrow and that lowers the supply of available money which in turn increases short term interest rates and slows the rate of inflation. Lowering the rate has the opposite effect, i.e., bringing short term interest rates down makes it less expensive to borrow money and that serves as a stimulate to economic growth. Raising the fed funds rate does the opposite and that’s what we are about to witness this month.
The corollary to this is the housing market. Over the past couple of years, after the Fed started driving down interest rates through “QE” (Quantitative Easing) and did so because of a potential slowing of our economy caused by Covid. People looking to buy a new home could now borrow money at some of the lowest interest rates in housing’s history. These lower borrowing rates fostered a surge of home buyers which allowed seller to ask more for their homes and well, you know the rest of the story. As the Fed starts to raise this month at its March 16th meeting it is our belief that we will slowly start to see the beginning of the opposite of this phenomenon, and it will be guided by how fast the Fed raises rates.
Another tactic the Fed may use after they start raising the fed funds rate this month is to decide that when a bond out of their $8.5 trillion portfolio reaches their maturity date the fed can either use that matured bond money to buy more bonds (which does not reduce their balance sheet) or simply let it “run off” its balance sheet therefore reducing the $8.5 trillion of total Fed debt. Understand that the Federal Reserve effectively “created” the money it used to buy the bonds out of thin air in the first place. Now the Treasury Department “pays” the Fed at the maturity of the bond by subtracting the sum from the cash balance sheet effectively making the money disappear which then reduces the number of bonds in the fed’s portfolio. All of this is referred to as “quantitative tightening” (QT).
The last time the Fed was transitioning from QE to QT it kept its balance sheet steady for about three years AFTER finishing its tapering (dropping the Fed funds rate) through the reduction of the Fed Funds Rate. It did that by using the money from maturing bonds to buy replacements. It didn’t turn to quantitative tightening (QT) until it had raised its interest rate target range from near zero to 1% to 1.25%. Many analysts believe we will see the same sequence again. From the first Fed taper initiated at the beginning of the 2020 COVID crisis, to todays anticipated rate hikes we are now entering the early stages of quantitative tightening (QT). To repeat, we have already witnessed the decrease of monthly bond buying (from $120 billion to $60 billion). Now we are going to see after the Fed’s March 16th meeting a 70% chance of a +0.25% increase in the Fed Funds Rate or a 30% chance of +0.50%. Many economists are betting there will be 5 increases in the Fed Funds Rate in 2022. We’ve also seen estimates as high as 7 increases.
I stated as far back as June of last year (2021) on America’s Wealth Management Show that my partner Dean Barber and I have hosted together for over 15 years, that the Fed was behind on raising the Fed Fund Rate and I believed at that time that they should have started reducing back in November or December of last year. I believe this has been born out to be true.
As the quantitative tightening (QT) process takes money out of the financial system, borrowing costs are bound to rise. Just as quantitative easing (QE) drove interest rates down, QT can be expected to put pressure on interest rates causing them to rise. As interest rates rise the price of some bonds will fall and furthermore stocks most likely will be under increased pressure as well.
Fed chairwoman Janet Yellen’s comments on QT stated in June 2017 that “this is something that will just run quietly in the background over a number of years, it will be like watching paint dry.” Later our current Fed chairman Jerome Powell, Yellen’s successor as Fed chairman, stated at one point that the program was on “automatic pilot.” But after the S&P 500 Index tumbled almost -16% over three weeks in December 2018, the Fed blinked and abandoned further rate hikes in January 2019 and further the Fed went on to announce the phasing out of QT in March 2019. So, did it work? In September 2019 interest rates surged in the repo market, a key source of short-term funding, prompting the Fed to inject short-term liquidity in its first such operation in a decade. The following month, policy makers said they would ramp up purchases of U.S. Treasury Bills to maintain an ample supply of bank reserves. Most people have probably forgotten our famous 2013 “Taper Tantrum”. This came about because of low reserves and higher foreign currency debt among emerging economies. The result was a surge in U.S. Treasury yields. Could that happen again? Highly unlikely this time around, but we should not forget the lessons of our past.
So, does the Federal Reserve have an additional plan of action as we embark on a potential series of Fed Fund increases? The Fed has new tools it can use to avert at least some short-term strains in financial markets. Last year, it introduced the Standing Repo Facility which can provide as much as $500 billions of cash overnight to the banking system. A separate facility offers dollars to other central banks around the world. The Federal Reserve Bank of New York can also mount unscheduled domestic repurchase agreements. A sustained spike in use of the facilities could serve as a signal of trouble ahead. With U.S. fiscal policy about to tighten this month (March 2022) and as our Covid pandemic relief spending winds down, and the trajectory and impact of the Fed’s QT program coming soon, moderation may very well be the key takeaway here.
Our new jobs number just came out today (March 4th) showing a strong increase of 678,000 new jobs added to the system February. While that is a solid number Russia’s attack on the Ukraine (among other things) has the U.S. 10-year treasury bond below 2 percent. It is historically unprecedented to have a less than a 2 percent 10-year treasury bond in context of a nearing 71/2 percent inflation rate along with a rising labor force. This seems to indicate that inflation could get worse and could easily impact the already impacted housing market. People are always talking about the “housing boom”, however in February mortgage applications for the purchase of a home were down -11percent from January a year ago. We also have an index of pending sales of existing homes declining over the last three consecutive months. This could be an early reaction to the Fed’s almost certain raising of the Fed Funds Rate expected this month. The Fed’s decisions moving forward are critical to avoid pushing our economy to slower growth. Add to the equation that wages are not keeping up with inflation and you have a situation that adds to the slow economic theme. If the economy slows to much corporate earnings would be under pressure which could in turn impact the stock market.
Not to be political, but we don’t understand why President Biden doesn’t reopen the Keystone Pipeline and allow increased production and even new drilling. At current levels of the price of oil we could even see us return to fracking. The U.S. currently imports an average of 209,000 barrels per day of crude oil and 500,000 barrels per day of other petroleum products from Russia. Personally, I support the “green initiative”, but not at the expense of doing business with Russia. I would rather, under our current global situation, want to be energy independent and be a net exporter of oil to our allies to support their needs as well as our own. As we understand it, 20 percent of Russia’s GDP comes from oil exports. In comparison our share of oil and gas and other related products represents 8% of our nation’s GDP. Oil exports for other countries as a percent of their GDP observes 50% for Saudi Arabia, 30% for the United Emirates, 14% of Norway’s, 13.3% for Kazakhstan and 10% for Canada. The perception is that Russia’s oil and gas exports represent nearly 50% of their GDP. The truth is that oil and gas represent 50% of all of Russia’s exports.
Since the days of Fed chairman Ben Bernanke’s successful promise of increased Fed transparency, which he delivered on, a lot of the suspicion and guesswork has been eliminated and continues today. Our nation’s current Fed chair, Jerome Powell, thankfully appears to be following the same track as Mr. Bernanke. True, markets hate uncertainty and tackling our nation’s financial issues is not a simple task, but in the words of former Treasury Secretary Lawrence Summers the four of the most dangerous words are “This Time Its Different!” We don’t think so!