Coaster brakes

repo market

Back in September, the U.S. Federal Reserve announced that their massive bond-buying program known as Quantitative Easing (QE) would begin to be reversed on October 1st, 2017. Given this momentous occasion (at least for bond nerds like us), we thought it would be useful to summarize, in laymen’s terms, the QE program, why it was implemented, and what reversing it might mean for the U.S. economy and financial markets. Let’s take a look:

QE is a process by which central banks create new money from nothing in order to purchase financial assets, such as Treasury bonds. The U.S. Federal Reserve has been busy implementing QE since the financial crisis in the fourth quarter of 2008, with purchases since the crisis totaling over $4 trillion. Mechanically, the Fed simply credits the reserve accounts of commercial banks at the Fed in exchange for the bank’s holdings of Treasury bonds or mortgage bonds. These can be both existing bonds and newly-issued Federal debt. The newly-created money stays on deposit at the Fed in the form of excess reserves.

During the financial crisis, the Fed also purchased other, lower-quality obligations such as commercial paper, corporate notes and mortgages. This was done to stabilize the financial system—one of the main goals of the initial tranche of QE. Banks, insurance companies, mortgage lenders, money market funds and others all needed cash when trust in the system collapsed in October of 2008. People realized (seemingly all at once) that the system was insolvent. Those who had excess cash refused to lend to all but the most creditworthy borrowers, so the Fed stepped in to add additional “grease” to the system. When it became obvious that ALL obligations within the system were backed by the central bank’s printing press, confidence returned.

The second goal of QE was to drive down interest rates in order to encourage risk taking within the markets and the economy. The Fed achieved this goal in spades. When QE began in October of 2008, the interest rate on the benchmark 30-year U.S. Treasury bond was 4.4 percent. Today it is more than 1/3 lower, at 2.8 percent. Short-term interest rates fell even more dramatically after QE, with most major deposit rates approaching zero immediately after the crisis, and remaining there for the next 7 years. Lower interest rates encouraged both bond and stock buyers to take more risk in search of higher cash yields, leading to higher prices. As mentioned above, bond prices have soared (they move inversely to yields) since the crisis. The S&P 500 Index, a proxy for U.S. stocks, has nearly quadrupled over the same period.

With financial markets booming and the U.S. economic recovery firmly in place (this week the Labor Department recorded 85 consecutive months of employment gains), the Fed appears ready to declare victory and go home. They recently said as much when they announced formal procedures and a timeline for reversing QE.

Here’s how the great Fed balance sheet “shrinkage” will work: The Fed began reducing their bond holdings by $10 billion per month in October. They aren’t selling any bonds, but instead allowing existing holdings to mature and not reinvesting the proceeds. The shrinkage then accelerates every three months thereafter until it reaches a rate of $50 billion per month—$600 billion a year—about a year from now. Then it continues apace until the balance sheet is considerably smaller. How much smaller? They won’t say. The point is that the central bank has begun the process of gradually destroying trillions of dollars created out of thin air during nearly a decade of monetary experimentation. This is a big deal.

Or maybe not. No one really knows what it means for the economy and the markets, because it’s never been done before. As we’ve written previously, JP Morgan CEO Jamie Dimon, leader of the nation’s largest commercial bank and proxy for financial gurus everywhere, recently said he has no idea how it will turn out. “We’ve never had QE like this before, we’ve never had unwinding like this before,” Dimon said. “Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.”

Now we’re living with it, and we’re going to learn a few things. One thing we do expect to emerge from the great “unwind” is a greater respect for, and understanding of, risk. Many have characterized the last nine years as a repressive period for real risk taking. That is, a period when enough financial “morphine” (i.e.; money) was pumped into the financial side of the economy to encourage complacency and a sort of “set it and forget it” mentality (Index fund, anyone?—just buy the S&P 500!) Meanwhile, the harder work—real capital spending and investment in capacity and training to give the average Josephine something to do beyond waiting tables—has been given short shrift.

Perhaps that’s about to change, as the Fed begins skimming $50 billion per month from the system. Maybe coasting is over; its time make real things again. Or, as we’ve also mentioned previously, maybe we’ll never have to do the hard things again—the robots will do them for us. Perhaps the central bankers have seen the future, and the previous nine years of morphine drip was simply the proper salve on the early road to human obsolescence. Now THAT would be a tough lesson.

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