No, the Federal Reserve Balance Sheet Unwinding Won't Sink the Markets

On Wednesday, Sept. 20, the plans for the $4.5 trillion Federal Reserve balance sheet unwinding were officially announced.

My inbox immediately filled up with questions about what this means for the markets looking ahead.

Federal Reserve Balance Sheet Unwinding

I also received links of hyperbolic columns from writers at Forbes, MarketWatch, and elsewhere.

There are no shortage of people out there right now saying that the U.S. Federal Reserve is going to crash the markets.

That word - "crash" - hits you like a jolt of electricity. It makes you want to close the screen, sign into your brokerage account, and SELL, SELL, SELL.

Before you break the enter key on your keyboard, let's explain what the Fed is doing, and then focus on the more immediate threats to the markets heading into 2018...

A Closer Look at the Federal Reserve Balance Sheet Unwinding

After the financial crisis eight years ago, the Federal Reserve stepped into uncharted territory.

As a massive liquidity crisis emerged, the central bank began purchasing trillions of dollars in government bonds, mortgage-backed securities, and other assets to provide much-needed support to the U.S. economy.

All told, the Fed balance sheet grew to anywhere from $1 trillion to roughly $4.5 trillion. That second number is almost one-quarter of U.S. Gross Domestic Product (GDP).

The Federal Reserve was trying to do three things with its massive stimulus program:

  1. First, it would provide capital needed to expand the economy and bolster GDP.
  2. Second, it would enable the central bank to support inflation levels as it targeted an annual rate of 2%.
  3. Third, the central bank aimed to bring the nation back toward full employment.

St. Louis Fed economist Stephen Williamson recently said there was no evidence that the balance sheet expansion helped the country reach those first two goals.

GDP growth has been lackluster over the last eight years, and inflation frustrations have made the Federal Reserve tepid about raising interest rates.

While the economy has slowly recovered over the last eight years, there have been unintended consequences. The Fed's bond purchases pushed down interest rates to very low levels.

Low interest rates have pushed investors into stocks and other assets, like real estate.

No doubt, the Fed's program provided a huge boost to the stock market. This naturally benefited the richest Americans who owned a lot of stocks, while lower- and middle-class Americans saw fewer benefits.

Now, after eight years of unprecedented quantitative easing, the central bank will begin to reduce the purchases of U.S. Treasuries and mortgage securities by $10 billion each month.

They will increase that figure by another $10 billion at the end of the year.

The central bank will continue to increase that figure to $50 billion during 2018.

People are worried because the central bank is effectively removing liquidity from the market.

The Federal Reserve isn't selling any of its assets. They aren't selling bonds or mortgage-backed securities. Instead, they say they will allow the securities to "roll off" as they mature. That means that they simply aren't going to reinvest.

There are two reasons people think this will disrupt the markets...

There are some who look at the past and say unwinding balance sheets will fuel a recession. The Fed has unwound balance sheets six times in the past, and five times, recessions followed.

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Then there is the other camp, the camp I find myself in. As a student of fiscal and monetary policy, this is the largest exercise of unwinding in market history. That said, there are many factors at play that simply create "the unknown."

The wind down comes at a time when other central banks around the globe have their own stimulus plans and could offer support.

During previous efforts to unwind the Fed balance sheet, there was no fully functional global derivatives market, no machine trading, and no major digitalized trading operations.

But there is also an expectation that the Fed will actively manage this wind down in a way that aims to address the associated risks.

Here's why I believe the Fed's balance sheet unwinding will not have the terrible impact on the markets that many pundits have claimed...

Has the Federal Reserve Learned from History?

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When Ben Bernanke began the quantitative easing process, he did so with history in mind. A student of the Great Depression, he argued that the sharp downturn of the 1930s was fueled by a liquidity crisis.

The United States was facing the exact same problem in 2009, which forced the bailout of Wall Street and the three stimulus programs designed to prevent a total collapse.

History can act as a proper guide, which is why the Fed will actively manage this wind down process and adjust based on market reactions. Back in May 2013, the markets experienced a downturn due to a "taper tantrum."

There are three things to keep in mind about the Fed's goals.

  1. This process of unwinding will happen at a very slow pace. The entire process has been compared to "watching paint dry."
  1. The Fed has already begun the tightening process and has sent plenty of signals to the market this year. Now, the central bank will be more active in its tapering. You will likely hear more at the next few Federal Reserve meetings about its tapering plans than you will interest rates.
  1. Interest rates are not going to rise significantly in the short term. The process of normalization will continue to take time, particularly as the Fed grapples with inflation.

Analysts at BNP Paribas have said that the economic impact of unwinding will have the impact of two interest rate hikes of 25 basis points.

As a result, the 10-year interest rate may rise to around 3%. Such a rise will also affect mortgages and auto loans and add pressure to the sectors at a time when pressures are mounting.

That said, we have to give the Fed time to play this out, because there has never been an unwinding of this size in the history of the markets. The Fed has not set any specific schedule, which means it will have flexibility to adjust its actions.

Because of these three reasons, I do not expect the Federal Reserve balance sheet unwinding to sink the markets.

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About the Author

Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.

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