This Aint Your Grandfathers Paint

June 16, 2017 - 6:22pm

 by Gary Wagner

Over the last couple of days, market participants have been analyzing and absorbing recent statements and actions initiated by the Fed at the conclusion of this month’s FOMC policy meeting. Analysts continue to parse the press release issued by the Federal Reserve, along with statements made by Chairwoman Janet Yellen during her news conference which followed the policy meeting.

The highly anticipated rate hike announced on Wednesday was largely factored into the market. However, the Fed revealed the mechanics and timetable to unwind the massive accumulation of assets on its balance sheets that were added during quantitative easing.

With the book value of 4½ trillion dollars, the Fed stated that they intend to “gradually reduce the Federal Reserve’s security holdings by decreasing its reinvestment of the principal payments it receives from securities held in the system open market account.” The press release went on to say that such payments will be reinvested only to the extent that they exceed gradually rising caps.

In layman’s terms, the Federal Reserve is about to hold a fire sale and liquidate assets from their balance sheets at the rate of $50 billion a month, when the program is in full swing. However, there is no need to be concerned because Fed chairwoman Janet Yellen has indicated that this action will be “like watching paint dry.”

While it is correct that it takes quite a while for paint to dry, simple math reveals that, at best, this monthly asset liquidation would require 3 ½ years just to ramp up to the Federal Reserve’s monthly caps. More importantly, this monthly liquidation of Fed assets would have the same net effect as a rate hike. Commonly referred to as a stealth hike, once implemented, financial markets would have to overcome interest rates that were now rising on a monthly basis.

Since quantitative easing required massive asset purchases by the Federal Reserve to move interest rates lower, the unwinding of this portfolio contains inherent risks due to unknown factors. According to the Federal Reserve, “The Committee expects to learn more about the underlying demand for reserves during the process of balance sheet normalization.” In other words, the Fed is clearly stating that the net effect of this liquidation is unknown.

What is known is that these monthly liquidations will ratchet up interest rates. Unlike a rate hike of 25 basis points, no clear-cut formula will forecast the level of interest rate increases that are a direct result from these monthly asset liquidations.  One can only hope that this massive undertaking by the Federal Reserve will, indeed, be like watching paint dry. Let’s further hope that when the paint dries, it does not produce a wall filled with cracks.

Wishing you as always, good trading,

Gary S. Wagner - Executive Producer