Will Unwinding the Fed’s $4.5 Trillion Balance Sheet Kill the Bull Market?

Will Unwinding the Fed’s $4.5 Trillion Balance Sheet Kill the Bull Market?


Over the last decade, investors have grown accustomed to a Federal Reserve that constantly coddled them, allayed their fears and did everything possible to support the financial markets and asset prices. The Fed also carefully communicated policy to avoid any nervousness in the hearts of investors and "verbally intervened" to nip any downturn in the bud — like back in late 2014, when stocks were careening lower on Ebola fears, and another round of bond buying was teased.

Now the worm has turned. The Fed has dramatically quickened its pace of rate hikes. Officials are becoming increasingly aggressive in their speeches, talking up the chances of as many as three or four rate hikes this year. And now, as revealed this week in the release of the March meeting minutes, policymakers are preparing to start shrinking the Fed’s balance sheet — which swelled from $1 trillion before the recession to some $4.5 trillion worth of Treasury bonds and mortgage-backed securities now — as soon as this year.

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This is a big deal. The Fed's bond-buying programs — multiple rounds of "quantitative easing" and an "Operation Twist" — kept the bull market on track through multiple scares: the Eurozone debt crisis and "flash crash" in 2010; the 2011 U.S. credit rating downgrade; the 2012 Greek bailout; the 2013 "fiscal cliff" and government shutdown; and the 2014 Ebola scare and crude oil meltdown.

Investors have now been programmed to believe any major negative catalyst doesn't matter because, if things get really bad the Fed will step in. It's the "Fed put" in action — the trite name for the idea that prices will only be allowed to go so low.

What's changed is that the Fed realizes that the job market is near maximum employment (with the unemployment rate below 5 percent and Baby Boomer retirements driving an ongoing tightening of the labor market) and inflation is reaching their target of a sustained 2 percent (with the PCE index now at 2.1 percent).

Moreover, asset valuations have become a concern. Within the meeting minutes, it was noted that some members believed stock market valuations were "quite high." This is a rare admittance for a body that, for years, has preferred to let the animal spirits roar. Fed Chair Janet Yellen warned of pockets of market froth back in 2014 — in biotech and big-tech stocks — but after a selloff resulted she quickly backed off her warning and hasn't repeated it since. 

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The Shiller Price-to-Earnings ratio, which takes a 10-year average of earnings so as to smooth cyclicality, has only been higher than it is now heading into the 1929 and 2000 market bubble peaks. Bonds are pricey across the risk spectrum, both in terms of absolute yield and yield spreads. Farmland values are lofty. Global real estate has bounced back (especially in areas attracting Asian capital, like Vancouver, Canada).

Save precious metals, pretty much everything is expensive right now, and the economy is running hot, especially if one considers the likelihood of simulative actions, including possible tax cuts and spending increases, by President Trump and Republicans in Congress. About half of the Fed policymakers have factored such stimulus into their forecasts.

Bank of America Merrill Lynch economists expect the Fed to start drawing down its balance sheet once the federal funds rate hits a range of 1.25 percent to 1.50 percent, which would require another two quarter-point hikes, widely expected in June and September. That means a portfolio drawdown could start late in the year, possibly in December, and be slowly ramped up.

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The result will likely be higher long-term interest rates, wider non-Treasury bond spreads (that is, higher mortgage and auto loan rates, for instance) and pressure on stocks as the discount rate rises. Also watch for a possible slowing of the debt-fueled corporate stock buyback bonanza as credit costs rise above equity earnings yields.

Other likely effects include a drop in bank deposit balances and loan activity and a rise in the dollar that could pressure commodity prices as well as dollar-denominated foreign loans as funding gets more expensive.

Long story short: Market volatility, which has been nearly extinguished by the Fed's ample liquidity, will make a return. After all, every bear market since the Fed was established in 1913 has been caused by tighter monetary policy.