In our 2017 State of the Bond Markets piece, we outlined how the U.S. Federal Reserve Bank (Fed) bought bonds from the open market in an effort to stimulate the U.S. and Global economies from the recession caused by the 2007 to 2009 financial crisis. Now in 2018, we would like to focus on the possibility that the Fed, and perhaps other central banks, will again make a policy mistake with massive ramifications.
Part 1: The Fed and It's Balance Sheet
Last year, we wrote about the Fed's QE program, the increase in our monetary base and some of the issues with the corporate bond market. As the chart below outlines, there were several stages of this quantitative easing (QE) but the net effect of it all was that the Fed’s balance sheet was increased from roughly $800 billion in 2008 to $4.5 trillion by 2015.
This large amount of QE stimulus was kept in place because any maturing, called or redeemed bonds were used to purchase new bonds and thus the effect of buying bonds at higher prices. With that, lower yields remained. The concern now is that the Fed will try to raise short-term interest rates too far and too fast. At the same token, they may also try to unwind the QE and monetary stimulus too quickly. Since all of the stimulus and the resulting record low interest rates are unprecedented, the unwinding of all of the stimulus presumably has also not been dealt with before.
This uncertain territory is filled with anxiety. We are concerned that the Fed will unwittingly drive interest rates higher too quickly resulting in a global economic recession. Unfortunately, as the chart shows, since 1914, the Fed's raising rates have resulted in a recession 85% of the time.
The next chart below shows how the Fed plans to unwind the QE bond purchases as stated in the Fed's September 2017 meeting minutes. The plan is to start selling $6 billion of U.S. treasuries and $4 billion of mortgage-backed securities a month, and to increase this amount each quarter until $50 billion a month is being sold back into the bond markets.
If carried out, this $600 billion annual rate of reduction will rival the speed and the amount of some of the QE programs themselves. As the chart below outlines, this QE reduction program already started in the fourth quarter of 2017.
Do you share the concern that we do for what is to come? Nobody can predict the future, but history tends to repeats itself. In this case, 85% of the time...
