Even a Fed dove! This could get interesting.
The Dow is titillating the entire world by verging for days within a hair of 20,000 without actually getting there. Hitting the Big One would be another reflection of what Trump had called during the campaign an “artificial stock market” in a “very false economy,” created by the Fed that had kept rates low “for political reasons.” The crowds ate it up.
He pointed out that “the only thing that’s strong is the artificial stock market,” which was “only strong because it’s free money because the rates are so low.” But there’d be a hitch: “At some point the rates are going to have to change,” he said.
“They’re keeping the rates down so that everything else doesn’t go down,” he told reporters when they asked him about a rate hike in September.
And the Fed listened. Now the Fed has raised the fed funds rate, after flip-flopping vociferously an entire year, and is playing with the idea of three more rate hikes next year. Even Fed doves are suddenly getting antsy, after luxuriating in eight years of ZIRP and six years of QE.
On Friday, it was St. Louis Fed President James Bullard’s turn. In an interview, he told the Wall Street Journal that the Fed should consider shrinking its $4.5 trillion balance sheet in 2017; it “possibly might be a good time to play that card,” he said.
During its five years of QE, the Fed has acquired $2.46 trillion in Treasury notes and bonds and $1.75 trillion in mortgage backed securities (MBS). As these securities mature, the Fed buys similar securities as a replacement to keep the balance sheet from shrinking. Thus, the Fed continues to be a powerful buyer in the markets.
This certainty that the Fed is buying assets infuses confidence into the markets and inflates prices. It lures investors into chasing yield in ever riskier assets with ever lower returns, resulting in low cost of capital for Corporate America. It has created what Trump called the “false economy” and the “artificial stock market” where financial engineering has taken precedence over investment in productive activities that would actually move the real economy forward.
That was the idea from the beginning. It’s the foundation under today’s dizzying asset prices.
Bullard would start by allowing maturing securities to roll off the balance sheet without replacing them with new asset purchases, he said. That would shrink the balance sheet. And it would make financial conditions more restrictive.
Shedding assets accumulated on the Fed’s balance sheet is the ultimate form of tightening. It would pull liquidity out of the markets and force them to stand on their own wobbly feet.
And he’s a dove! He sees only one rate hike next year. Until recently, he saw only one rate hike, period – the one we just got – and no additional hikes over the next few next years. But he’s ogling the balance sheet.
If shrinking the balance sheet is too radical for now, the Fed could replace longer term securities as they mature with short-dated securities, he said. This would make unwinding the balance sheet easier, once the decision is made. These short-dated securities could just be allowed to mature without replacement. It could go pretty quickly.
“My preference would be to allow some runoff in the balance sheet,” he said. But before markets could spiral into a paroxysm, he added that he didn’t think efforts to shrink the balance sheet were “imminent.”
He has been a voting member of the Federal Open Market Committee, which makes the decisions on rates, QE, and balance sheet shrinkage. But next year, he’ll rotate into a non-voting slot. So he’s just setting some trial balloons adrift.
A few Fed heads have dared to suggest that they’d want to shrink the balance sheet eventually, possibly after everyone’s life expectancy expires. They’d want to raise rates first, and if the economy hasn’t fallen into a recession or worse by then, it might be time to think about letting the balance sheet contract.
But the economy might never get to where there are some sort of normal rates without a recession. And a recession would start the whole process of rate cutting and perhaps QE all over again, and the balance sheet might never be shrunk in this scenario.
Bullard doesn’t want to wait that long. For good reason. QE has caused enough distortions.
Shrinking the balance sheet by allowing bonds to roll off, while keeping the fed funds rate relatively low, for example at 1.5% by next year, would cause long term rates to rise sharply while keeping a lid on short-term rates. It would steepen the yield curve. In this scenario, the 10-year yield – at 1.38% in July and now at 2.6% – might go to 4% or beyond.
It would have an epic impact on Trump’s “artificial stock market.” It would cause all kinds of mayhem, because Trump was right: The epic bond market bubble and the stock market rally that has pushed all conventional metrics off the charts have been fueled by the Fed.
The effects of removing, to use Trump’s term, the “artificial” elements from the stock market could be interesting. We’d have to avert our eyes from the carnage in the bond market. And Housing Bubble 2, with 30-year fixed-rate mortgages at 6%? That’s historically low and worked just fine ten years ago (it helped create Housing Bubble 1). But with the inflated home prices of today, it would mark a big reset.
Today’s equations won’t work at these interest rates. The fireworks could be astounding. But in the big picture, it would just unravel some of the excesses of the past few years, bring a hue of normalcy to the markets, and refocus attention on the real economy instead of wild financial speculations. Trump, as he was talking during the campaign, should appreciate that. Trump, as mega-investor, might get queasy. And Trump, as President, would be more than embarrassed to see financial markets sag under his watch.
The Fed already has plenty of reasons to move. Businesses expect their input prices to jump by 4.6% in 2017. Read… No Demand, No Problem: Inflation Pressures Surge