Introduction - it's mostly about the Fed, and it's (finally) getting better all the time for the market
The Federal Reserve may now be waking up to a point it was denying: it's easier to inject empty monetary calories into a broken or recovering financial system than it is to remove them years but not decades later (I counsel extreme patience on that front). Increase interest rates and remove USD, even "excess" reserves, from the global financial system and, predictably, the pace of business slows down. Also predictably, markets will tend to over-react to that slowdown as liquidity is removed pari passu with the slowdown.
Not wanting to become another Herbert Hoover, President Trump criticized the Fed's double-barreled tightening policy sharply in October. I agreed, and concluded an article on the topic this way:
Rate hikes alone without monetary deflation may have been enough from Day 1, and at this point, with housing perhaps topping and autos moving downhill, even the rate hikes could now reasonably be paused. They teach drivers to come to a full stop at stop signs, look around, and proceed only when it is safe to do so. I would say the same now to the Fed. Please...
As a giant institution that tends to move slowly, the Fed did not stop, and a bear market followed. But things were about to change, one hopes not too late: In a major about-face, the chairman of the Federal Reserve has described a new plan for it to begin a form of QE forever, but in a restrained manner, not QE to infinity.
Here's what Fed Chairman Jerome Powell said to Congress, and some implications.
Powell begins to reverse course
Per Bloomberg, from a week ago:
Federal Reserve Chair Jerome Powell told lawmakers that he'll soon announce a plan to stop shrinking the [Fed's] $4 trillion balance sheet...
The Fed's bond portfolio amounted to about 6 percent of gross domestic product before the crisis. Powell said Wednesday that the balance sheet will likely settle around 16 or 17 percent of GDP. He said the Fed "can't go back to that very small balance sheet," because shrinking it means draining the reserves demanded by banks, which are required to hold high-quality and liquid assets. He added that the Fed has learned that it's "good to be very careful with the balance sheet."
I've been focusing on effects on asset prices of the Fed's balance sheet reduction (reverse QE aka QT) since 2017. So I'm in complete agreement about being "careful with the balance sheet." One of the summary bullet points from my July 2017 article titled Reverse QE Is Very Different From Rate Hikes; How It Matters shows my thinking nearly two years ago:
... reverse QE could be an important "risk off" program, with no obvious winners in any financial asset class other than cash reserves.
That was written 10 weeks before reverse QE began at the starting $10 B per month level of liquidity withdrawal. Mostly because of delays in settlement of trades, the Fed's balance sheet (its assets) did not decline until December 2017. Then, what followed after the blow-off market top in January 2018 was in line with what I said. Reverse QE ramped up, and by Christmas, cash was more or less the best asset class for the year, even including the booming January for equities. In other words, remove cash from the system, give it just a little yield, et voila: it goes from trash to the best asset class.
So: remove hundreds of billions of dollars from bank accounts, make cash yield something as in days of yore, and asset prices struggle - both stocks and bonds - but especially risk assets.
Now we have an upcoming and more favorable change in the investment weather that may keep markets holding together.
Let's look at what a Fed balance sheet of 16-17% of GDP means.
Estimating the future money supply
Briefly, the Fed creates money, aka bank reserves, "out of thin air," buying assets, almost always bonds, with this thin-air money (or, credit). Since October 2017, the Fed has been reversing the prior QE era by letting maturing bonds it owned roll off its balance sheet, thus letting shrinking its balance sheet and therefore shrinking the base money supply of the United States. Per prior Fed guidance, this process could have gone on well into 2020 and perhaps into 2021, posing major headwinds for all financial asset prices, especially risk assets such as stocks.
But if we assume the Fed's balance sheet is going to normalize around 1/6 the level of GDP, we can assume that one of these days, the balance sheet will grow again, meaning that the Fed will resume buying bonds with money created out of thin air. In other words, endless QE.
To quantify matters, we need to look at GDP. As of Q4, GDP was estimated to be annualizing at $20.9 T, rising at a 5.3% rate. That would imply that the Fed's desired balance sheet right now would be $21 T/6 = $3.5 T.
Per the Fed's latest, Feb. 28 H.4.1 release, its balance sheet came to $3.975 T (Table 4). Of that, $3.8 T consisted of securities held outright, mostly Treasuries as well as lots of mortgage-backed securities. (Note, the Fed values its gold at $11 B, but fair market value is around $330 B.) If the Fed were to shrink its securities holdings by $50 B/month for the 6 months from March-August, inclusive, that would take its balance sheet down to $3.7 T. But, GDP is assumed to be rising, and certain trades the Fed makes do not settle promptly. So I will guess that by August-September, the Fed will stop its reverse QE program and begin the process of inflating its balance sheet again. It could stop the process now, but it is not hinting at that to my knowledge.
Details should be announced soon, allowing fine-tuning of this model.
Implications for valuations
In the very short run, the flow of liquid assets out of bank assets that must go to purchase Treasuries and mortgage-backed bonds continues to be a negative. That's short term now and may not matter much barring a crisis, when liquidity does suddenly matter.
I am now assuming that the Fed will follow through more or less as laid out above and calculating things this way.
If GDP rises 14-15% to $24 T in three years, then the Fed's balance sheet would be unchanged from its current level, at $4 T. Looking farther out, and modeling a 4% CAGR in GDP, 2029 GDP would reach $31 T and the Fed's balance sheet would be about $5.2 T. From then to now, the CAGR in the Fed's balance sheet would be a cautious 2.3%.
Modeling 5% GDP growing at a 5% CAGR would take GDP to $34 T and the Fed's balance sheet near $5.7 T, a 3.6% growth rate in the balance sheet.
2.3% and 3.6% are mildly restrained growth rates. For example, FRED shows a 4.25% CAGR of the Fed's balance sheet between Jan. 2003 and Jan. 2007 (older data is not shown there).
All this looks unremarkable to me. I'm therefore thinking and hoping that again, interest rate policy may soon become the only Fed focus for investors.
Conclusion - a happy ending?
If the Fed is permanently enshrining QE, with substantial "excess" bank reserves the new normal, is there an important downside for investors? I do not think so, at least not any time soon. Rather, it's sort of Goldilocks-ish: not too... anything. Rather, in normal economic times, the major asset classes all look investable:
- Plain vanilla money market funds, such as one from Vanguard (VMMXX), are yielding close to 2.5%, which meets or beats PCE inflation.
- Equity investors can now look longer term, as we always need to, and can see the basic money supply increasing at a reasonable but non-inflationary rate.
- Bondholders can look at the flat yield curve all the way out to 5 years for Treasury and corporate bonds (the muni curve is steeper) and say the Fed has tightened as much as it should (or more). But there is some yield pick-up by going longer than 5 years.
If inflation picks up, the Fed can easily resume hiking rates, so policy is not being constrained. If markets get frothy (or, frothier if you think they are frothy already), the Fed can adjust its policy to shrink excess reserves, which act as hot money. If the economy or markets go south, the Fed can react appropriately.
All the usual investment risks exist - the known and unknown ones - but many of them do not trouble me as an owner of long-tailed investments. Brexit? Well, the Brits and parts of the mainland have been quarreling for at least 953 years. China trade war? Transitory; something will happen, then something else. Global slowdown/recession? Certainly it's a current issue. But wait a year or three, or longer. The next 'problem' might be growth that's felt to be too strong, not too weak.
This is the first time in more than a decade commenting on financial matters where I'm seeing the Federal Reserve adumbrate a coherent plan that can work for the long haul. Let's see the details and then whether the Fed actually can stick to the plan. If so, the era of high P/E's and low interest rates may be set to hang around a good while longer, as excess bank reserves/excess hot money becomes official policy.
Tranquilized by a more stable, predictable, rules-based Federal Reserve policy on the money supply, Goldilocks may sleep soundly, and maybe the bears will keep their distance. Here's hoping!
Thanks for reading and sharing any thoughts you wish to contribute.
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.
Additional disclosure: Not investment advice. I am not an investment adviser.