Federal Reserve Exit Watch - Once Again: Part I

Includes: DIA, IWM, QQQ, SPY
by: John M. Mason

I have tried several times to write about a Federal Reserve Exit. Well, since "tapering" has begun…I will try to create a Federal Reserve Exit Watch…Once Again.

So it is official…the Open Market Committee of the Federal Reserve System has voted to begin to reduce the amount of securities that it purchases every month. The Fed is dropping purchases from $85 billion per month to $75 billion per month. In other words, rather than driving the car at 85 miles per hour with the rest of the cars following at close range, the Fed is now going to be driving the car at 75 miles per hour. So…everyone will have to slow down somewhat.

This is a "tightening" because if people are still expecting to go 85 miles per hour right behind the Fed…they will crash.

I know many of the Fed don't want to think of this move as a "tightening"…they still want to say…we a still going very fast…and this is just a modification of our speed. But, a slowdown when everyone else is expecting a faster speed…is a tightening!

Also, we are soon to have a new Chairperson of the Board of Governors of the Federal Reserve System. Janet Yellen, a fine economist and an experienced Federal Reserve official will be taking over later this month. She is expected to have a "heavy" foot on the gas pedal…and will err on the side of too much speed…but also realizes that the Fed…and the economy…has to get back to a more normal world situation.

It is going to be interesting to see how this more "normal" world situation is achieved. As I wrote last week, I still believe that "the biggest market risk for 2014 is the Fed getting it wrong."

That is why I am going to cover this "exit" closely and try to discover what might be going right, what might be going wrong, and how one needs to position their investments in such an environment.

Things are changing and we need to be aware of them.

After several years when the Reserve Balances with Federal Reserve Banks (a pretty good proxy excess reserves in the banking system) increased every month, we can report that in the past four-week period these reserve balances actually declined.

From December 4, 2013 to January 1, 2014, the line item on the Federal Reserve H.4.1 release actually declined by a little more than $260 billion.

Now, this decline did not occur because of the Federal Reserve slowdown in its purchase of securities. The Fed actually added or supplied to reserve balances a net total of more than $88 billion through its net purchases of securities.

The two things that "absorbed" a lot of reserves and resulted in the reserve balance total going down.

The first of these was a seasonal swing in the deposits the US Treasury holds at Federal Reserve banks. Toward the end of the year, funds that have come into Treasury accounts at commercial banks are removed from the commercial banking system and transferred to the Treasury's General Account at Federal Reserve banks.

This year, in the period from December 4 to January 1, the Treasury account actually grew by almost $190 billion. That is, $190 billion left the accounts of commercial banks at the Fed and moved to the General Account of the US Treasury.

The second move that impacted Reserve Balances was an increase of Reverse Repurchase Agreements. During the four-week period ending January 1, the Federal Reserve engaged in an increase of almost $190 billion in reverse repurchase agreements. That is, the Federal Reserve sold to government securities dealers $190 billion in securities under an agreement to repurchase them again in the future. Transactions like these do not change the amount of securities the Fed reports on its balance sheet, but it does mean that the Fed absorbs some "commercial bank" money while the transaction is still outstanding.

The Federal Reserve has indicated for a long time that it was going to engage in transactions like these in order to be prepared to "remove" reserves from the banking system. It has stated in the past that these efforts were "trial runs" to prepare the Fed and the market for the day in which reserves would actually need to be removed from the banking system.

Well, it looks as if the Fed is really trying to get ready for the day!

The net consequence is that for the first time in a long time, the banking system actually saw its reserve balances decline! We need to continue to watch this activity closely!

During this time period, the Federal Funds rate did not seem to be impacted by the drop in these reserve balances. For the full four-week period the effective Federal Funds rate traded at around 8 to 9 basis points, close to the low end of the current range for the Federal Funds rate as set by the Federal Reserve System. That is, the decline in reserve balances did not put any pressure on the Federal Funds market that required any Federal Reserve action.

Over the past 52-week period, the Fed added a net amount of $1.1 trillion in securities to its securities portfolio. During this time period the Fed added a net amount of $543 billion in government securities to the portfolio and a net amount of $564 billion in mortgage-backed securities to the portfolio.

Reserve balances at Federal Reserve banks, for this 52-week period, rose by $740 billion. This figure would, of course, be closer to the $1.1 trillion addition to the securities portfolio had it not been for the action on reverse repos that took place over the last four weeks of this time span.

A lot is going to change with respect to Federal Reserve actions over the next 52-week period. It is my belief that these actions are going to have to be closely watched. Furthermore, we are going to have to see how the banking system and the financial markets are going to react to these actions. For one thing, I think it is obvious to write that the volatility of the financial markets is going to rise this year.

Officials at the Federal Reserve, particularly under the leadership of Mr. Bernanke, have attempted to provide the financial markets with more "openness and transparency" through there "forward guidance" programs. I believe that these efforts will just lead to more volatility, rather than less, because the people who run the Federal Reserve and make the forecasts about the economy and financial markets are…guess what…only human! And, humans make mistakes and are…by and large…not very accurate forecasters.

My bet is that the efforts of the Federal Reserve to provide "forward guidance" to the financial markets interacting with the actual outcomes of the economy and the financial markets will play off one another and create even more volatility than we have experienced in recent times. It is my belief that within two years "forward guidance" will be tossed aside because of its uselessness.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.