Intro and Takeaway Questions

Talk and expectations for a change in monetary policy are in the air. The policy members plan at an unknown date to taper the volume of the Fed’s bond purchases, perhaps shrinking their balance sheet as their previously purchased bonds mature and roll off. What are the implications?

This article looks into structural implications and the resulting questions such as:

  • How and how much will long term interest rates change?
  • Basic financial market reactions, modest or severe?
  • What may happen when moving from plenty of cash, plenty of debt issuance and balance sheet availability to a more modest level on these item
  • How much change lies ahead for the Fed balance sheet and growth or diminishment of cash?
  • Basically, when and how much tapering lies ahead?
  • When does the FOMC make the change and announce a calendar pan for further changes?
  • Will the financial markets become volatile after so many years of lavish monetary policy.

Fed Policy Changes

The Fed’s tools prior to the 2008 financial market setback, were limited primarily to controlling the money supply via operations using repo markets to affect target levels on short term rates and the Fed Funds rate.

The massive deleveraging in 2008 due to a fallback from lavish and excessive lending went beyond replenishing liquidity with the Fed’s modest balance sheet and modest injections to the money supply. Quantitative easing became a new Fed tool, purchasing bonds, effectively shouldering the burden of backstopping the downfall of too much debt, too much leverage, and the resulting collapse of confidence.  It worked, but it took years to bring the markets back into positive territory as well as getting the economy back to its pre-crisis level. QE, as they say, has been a fixture ever since.

Now it is time for a reduction in the Fed’s balance sheet. Bond purchases remain on the Fed’s balance sheet, and QE is a long run policy. Open market repo is a day-by-day policy tool. QE is a softer influence but powerful one, while short-term management of short-term rates has more immediate punch. The Fed apparently will opt for QE reduction and balance sheet winddown through runoff. The adjustment in short term rates and Fed funds comes later. And importantly there will be a new tool added which is a supportive repo facility in a size that buffers any cash crunch to the system, perhaps due to policy changes.

Resulting Higher Rates

Eventually, as the Fed lessens its purchases of US Treasuries and Mortgage-Backed Bonds which it buys, the financial system will need to carry the supply of bonds by itself with less or no support from the Fed.  Additionally, when the Fed buys bonds, it does so by issuing into the system which increases the monetary base.  Central banks can increase or decrease the monetary base through various forms of monetary policy. For many central banks, the monetary base is increased through the purchase of government bonds, also known as open market operations. Open market operations, although similar to QE, is more day-to-day control of need flows or excess money in the system as a means to maintain a target level for Fed Funds.

The increase in the base in turn lifts the money supply. The Fed grows its balance sheet with QE and a diminishment reduces leverage to the system and reduces injections of money into the system. The result? Higher interest rates. Short term interest rates and long-term interest rates will adjust quickly and will include further policy changes ahead. Bond interest rates will initially mathematically adjust but positioning influences in the markets will vary interest rates as well. Assets with larger expectation components may be more volatile.

What Are The Impacts?

Fundamentally, higher interest rates will not only increase the cost of borrowing, but they also increase the discounting factor, reducing asset prices, such as bonds and equities. Normally a small change in interest rates upward does not create a rout. It did so in December 2018, with the Fed’s announcement of raising rates and more to come. Stocks dropped reaching 20 percent off their highs, and the Fed reversed course to end the reaction.

There is a liquidity change ahead with the Fed changing policy. Cash, and lots of it, has been the rule lately. So much so that the market has placed as much as 2 Trillion dollars back to the Fed using short-term reverse repo with the fed.

With all this cash — why worry? Future policy changes are apt to relate to changes in short-term rates, drawing cash and liquidity levels downward given lass support. The Fed plans a new facility for handling sizeable injections of Repurchase Agreements which in a pinch, allow banks to borrow using the bonds they own as collateral. This gives money back into the system if need be, going beyond time and size parameters of open market operations. Yet, here we are, drowning in cash and low interest rates currently. It would take a massive market reversal to reach a point where the new facility is in play. But the experience in 2018 needs to be kept in mind. In other words, do we really know how much the market will react?

Regulated Risk Levels

A short point to mention here is that the banks are now limited and monitored by the Fed for their capital adequacy. In other words, they send cash back to the Fed these days perhaps due to the limitations on the size of their balance sheet. This means they are not a buffer, absorbing assets from clients selling assets as prices decline. I imagine in an emergency marketplace, the Fed will instruct banks to be friendly again, and the Fed insures the banks. Otherwise, all the excess risks of inflated markets reside outside the banks. Will this initially prove to be more volatile for the world’s many non- bank portfolios?  

Messaging, All Important

The best way the Fed can avoid a repeat of the 2018 sudden deep decline in equities as well as liquidity in general, nicknamed the “Taper Tantrum,” is to deliver their plans and unknowns for the economy well in advance (after all, that’s the premise for policy changes).  Influencing expectations for the future is key. Looking to make changes in a year or two gives the market a chance to make plans. The trouble is, we do not know when or how much exactly the Fed plans to do in its upcoming policy changes.  So, the market wobbles with changing data and therefore likelihood. But the Fed itself is data dependent, so we balance between cash-driven investing driving the markets higher and future policy changes that send the markets lower.

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Tom Kutzen using