Fed Trek — The great balance sheet unwind
These are the voyages of the Federal Reserve. Its five-year mission: To unwind a massive balance sheet, to seek out inflation and low unemployment, to boldly go where no man has gone before.
There was no shortage of news last week as the S&P 500 (^GSPC, SPY) closed at another all-time high. Kim Jong Un threatening a thermonuclear test over the Pacific, followed by some name calling between the North Korean dictator and our president would likely top most lists. Maybe we should discuss the B1 Bomber fly-by of the Korean Peninsula with a full F-15 Strike Eagle escort. Terrifying events for sure — but here’s what flashed red on my news feed.
BREAKING NEWS! Fed Chair Yellen admits in a press conference that after creating $4.5 trillion out of thin air, the Federal Reserve can’t figure out why it couldn’t buy a little inflation along the way. Following the FOMC decisions, when she was asked about the inflation rate being suppressed, she said, “I will not say that the committee clearly understands what the causes are of that.”
That’s a pretty big admission, given that a 2% inflation target has been the centerpiece of Fed policy since the dawn of the financial crisis. It’s true: Inflation in its traditional forms has eluded the recovery, especially when it comes to wages for the average American.
However, I think the above ignores the fact the last eight years may have been the most inflationary in decades. Asset inflation on the heels of artificially suppressed interest rates has driven financial instruments to dizzying heights, enriching anyone who went along for the ride.
It’s true that those in the middle, who continued to add to their 401(k)s, did well. But I believe the case can be made that the bulk of the gains went to the top 1% of the nation, which owns an extraordinary amount of physical and paper assets. Real estate, stocks and bonds are all at — or close to — all-time highs and make up a substantial portion of top-tier wealth.
I’m not saying it was its intention, but the Fed’s actions since the financial crisis are likely the single biggest contribution to the widening gulf between the uber-wealthy and everyone else.
Was it avoidable? Maybe not. History will be the judge as we now enter unchartered territory. With a $4.5 trillion balance sheet on the books, Fed officials will be the first to tell you we haven’t been here before. Just what the market reaction will be as the $10 billion per month reduction slowly increases to $50 billion is anyone’s guess — and that’s just what it is: a guess.
Intuitively, the long end of the curve should push higher as the unwind changes the supply demand dynamic. As rates go higher, bonds should become more competitive forcing P/Es (price-to-earnings multiples) lower.
Hopefully, the geosynchronous growth we see around the world will be enough to offset the monetary policy drag. If foreign markets are strong, then likely our customers are doing well, and that should be good news for U.S. multinationals dependent on global growth.
There are many Fed officials who believe the new program should be placed on autopilot. Despite any rhetoric to that end, it doesn’t fit in with anything we’ve seen from an incremental Fed over the last eight years. Movement has come slowly, and I suspect — no I’m certain — that if it saw the economy in jeopardy, it would quickly slow down or even halt the process until conditions improved. Fed officials are very much market watchers, sensitive to any temper tantrum from investors.
For now, markets believe the Fed can pull it off. Even if it does, that isn’t the end of the story. Like Star Trek, there’s always a sequel. Central banks everywhere are watching the Fed and how the economy responds. With Germany and Japan on deck, we’ll have to watch this movie again as they travel down a similar path to normalization.
For now, the seas are calm, and threats seem contained. However, without history as a guide, the Fed is forced to chart a course with little information on what lies ahead. Call me a cynic, but somewhere along this journey we’re going to wish we could grab a cellphone and scream, “Beam me up, Scotty!”
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