The Federal Reserve System seems to be the steadiest hand in the financial markets these days.
As volatility swirls around the markets throughout the world, the officials at the Federal Reserve seem to be comfortable with the path that they have staked out for themselves and do not seem to feel the need to respond to any of the movements… up or down… that are moving the markets these days.
The Federal Open Market Committee moved the target range for the Federal Funds rate at its March meeting and almost everyone is expecting that the FOMC will make another move at the next meeting that will be held on June 12 and 13.
These moves are consistent with the “forward guidance” given by Fed officials some time ago.
Market participants give a high probability that the Fed will raise the policy range one more time this year, but, recently, the feeling is less strong that there will be two more moves this year.
The original “guidance” was for only three changes this year, but as conditions have changed, the feeling that there may… or may not… be a fourth one has fluctuated.
The important thing, however, is that Federal Reserve officials seem to be focused on a steady path for further increases. And, this feeling seems to apply to the new appointments to the Board of Governors coming on board throughout this year.
This behavior seems to be sending an important signal to the financial markets. That signal is one of continuity.
Yes, the Federal Reserve has been raising its policy rate of interest for two and one-half years now, but as it has been raising the rate, it has also maintained sufficient liquidity in the banking system so that commercial banks feel comfortable with their balance sheet position and that the stock market is assured that the Fed still wants to see stock prices go up.
This last point is particularly significant because the economic recovery from the Great Recession was underwritten by a Federal Reserve that was intent upon creating a “wealth effect” related to rising stock prices. This effort was begun by former Fed Chair Ben Bernanke and then continued by his successor, Janet Yellen.
This market attitude was continued up until the end of January 2018, the time of Ms. Yellen’s departure, as market participants wondered about how Mr. Jerome Powell, the new Fed Chair and President Trump’s appointment to the Board of Governors, would conduct monetary policy going forward.
The stock market hit a new high on January 26, 2018, with the S&P 500 closing at 2,873 and has bounced around ever since trading around 2,745 on June 4, down about 4.5 percent from the earlier date.
I believe that people are getting more comfortable with the leadership of Mr. Powell and that he will guide the Fed on much the same path as Ms. Yellen was moving on. Of course, other things could happen to divert Fed officials, but, in general, I believe that market participants are “trusting” that the Fed will continue on its path to slowly raise its policy rate of interest while keeping the banks sufficiently supplied with liquidity to not threaten the stock market.
I do believe that financial markets, including the stock market will continue to be highly volatile in the near future, more so than during almost all of the economic recovery from the Great Recession, but, that the Fed will continue to support a strong market.
This may become a more challenging task as the Federal Reserve continues to reduce the size of its securities portfolio.
We are now in the ninth month of this effort, and so far, it seems, the portfolio reduction has gone particularly well. Although the Fed is not precisely on target, it is sufficiently close to its original plan that it can be considered to be “on target.”
From September 27, 2017 through May 30, 2018, the size of the Fed’s securities portfolio has declined by about $125 billion. The proposed reduction through the end of May was $150 billion.
The reduction in May alone was just over $38 billion, when the original plan was for a May reduction of $30 billion.
The reduction effort has proceeded without any apparent market disturbances or interest rate bounces. So, it looks like a job well done.
The plan is for another reduction of around $30 billion to take place in June before the number jumps to $40 billion per month for July, August, and September.
The reduction in commercial bank “Reserve Balances” on the Fed’s balance sheet, a proxy for “excess reserves,’ has been somewhat greater, reaching $173 billion. This is because the Fed is no longer using some of the tools it used to manage the balance sheet during the time the securities portfolio was held roughly constant, like reverse repurchase agreements. Not using these tools has resulted in a decline in the banking system’s ‘excess reserves.”
However, all this has been done in a way that has not seemingly disrupted commercial banking operations or financial markets.
As I have written before, I believe that this effort is going to become much more difficult to maintain. There is just too much going on in the world, and the Federal Reserve is in such a central position. In fact, it is remarkable to me that the Fed has been able to continue along the road it has for this long of a time.
One of the things I believe we need to watch in upcoming months is the value of the US dollar.
After rising throughout 2017 and into early 2018, the value of the dollar peaked around February 1 of this year and has risen relatively strongly ever since. This rise is impacting many different areas of the world. For example, Europe is having its problems with Italy… and Spain… and Greece… and this has consequently helped to weaken the Euro relative to the dollar and it has put Mario Draghi and the European Central Bank in a tough position because the ECB had hoped to start raising its policy rates of interest this year.
Then there is the situation of the emerging market nations. The rising value of the US dollar, along with economic… and political… difficulties in these places has raised some concern over sovereign stability and sustainability.
Then, there is bound to be a noise raised in Washington, D.C., if it is perceived that the stronger dollar is hurting the performance of the US economy.
So, the near future contains many possible situations that could disrupt Federal Reserve actions. These need to be watched, but, I believe that they need to be watched in terms of what Federal Reserve officials are attempting to achieve. How the Fed reacts will also be an important indicator of what is going on and of how our officials believe that these events should be responded to. All I can say from this is… ”hang on.”
Disclosure: I/we 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.