The $4.5 Trillion Gift

Let me tell you a little story. Let me tell you a little story. It starts in November 2008 when the Federal Reserve launched an $800 billion bond-buying program to lower lending costs for borrowers as well as home buyers. The program was called “quantitative easing” (QE), which sounds like gentle and vague academic talk. This was on the heels of the financial meltdown earlier that year, and it didn’t end until October 2014 – a hair under six years.

By then, the Fed’s balance sheet grew to about $4.5 trillion in assets – assets, mind you, it created out of thin air. Well, let me clarify: The assets weren’t created out of thin air, just the money to pay for them, although to me that seems like a distinction without a difference.

The Fed Chair at the time, Ben Bernanke, announced an end to QE in June 2013, but after a rather large stock market drop (known as the “taper tantrum”) within a three-day period, he decided to hold off. It would be the current Fed chair, Janet Yellen, who would finally end the program in 2014.

So, from 2008 through 2014, the Fed used every tool it had to fight deflation, create jobs, and grow wages. The unemployment rate finally shrank to 4.5%, and inflation grew to its 2% target (just this year).

And so the Fed can argue that low unemployment and stable prices are the result of its policies – eight years’ worth of artificially low rates along with QE.

They can argue it, but I’m not buying it!It starts in November 2008 when the Federal Reserve launched an $800 billion bond-buying program to lower lending costs for borrowers as well as home buyers. The program was called “quantitative easing” (QE), which sounds like gentle and vague academic talk. This was on the heels of the financial meltdown earlier that year, and it didn’t end until October 2014 – a hair under six years.

By then, the Fed’s balance sheet grew to about $4.5 trillion in assets – assets, mind you, it created out of thin air. Well, let me clarify: The assets weren’t created out of thin air, just the money to pay for them, although to me that seems like a distinction without a difference.

The Fed Chair at the time, Ben Bernanke, announced an end to QE in June 2013, but after a rather large stock market drop (known as the “taper tantrum”) within a three-day period, he decided to hold off. It would be the current Fed chair, Janet Yellen, who would finally end the program in 2014.

So, from 2008 through 2014, the Fed used every tool it had to fight deflation, create jobs, and grow wages. The unemployment rate finally shrank to 4.5%, and inflation grew to its 2% target (just this year).

And so the Fed can argue that low unemployment and stable prices are the result of its policies – eight years’ worth of artificially low rates along with QE.

They can argue it, but I’m not buying it!

In December 2015, a little more than a year after QE ended, the Fed hiked rates by a measly quarter point because, by all accounts, the economy had turned the corner and it was time to normalize rates. Remember, not only did the central bank surprise the markets by hiking, but it implied it would hike another four times in 2016.

Well, the market was down slightly at the end of 2015 after the Fed hiked but turned sharply lower after the New Year. When all was said and done, the S&P 500 was down nearly 12% by early February. And that ended the Fed’s hope for multiple rate hikes in 2016.

Finally, in December of last year, in its one and only act of 2016, the Fed hiked rates again. In its statement, the Fed once again implied multiple hikes in 2017. But this time, the markets didn’t collapse, the sun still came up the next morning, and the Fed pulled the trigger and hiked again last month.

The Fed statement reiterated in March that it’ll continue rolling over maturing Treasury securities and continue reinvesting principal payments on all the debt it’s accumulated. What wasn’t mentioned in its March policy statement (but was in the minutes released earlier this month) was that it intends to start reducing the size of its balance sheet.

That’s huge news! The Fed will start unwinding the massive $4.5 trillion balance sheet.

In case you didn’t know, the Fed sends the U.S Treasury all earnings (less expenses) from the interest bearing bonds they paid nothing for. From 2005 to 2008, the Fed sent on average, $30 billion per year to the Treasury. Since the Fed’s balance sheet climbed, so did payments to the Treasury. From 2014 to 2016, the Fed sent, on average, $95.5 billion to the U.S. Treasury – or more than triple what sent eight years earlier!

But what happens when the debt the Fed holds matures? You guessed it! It will send the balance along with the interest earned to the U.S. Treasury.

What happens to interest rates when the balance sheet shrinks? That’s an even better question, because that will effectively be a rate hike. Eventually, the Fed won’t be reinvesting proceeds to buy more securities (Treasury bonds). And if the market doesn’t pick up the slack, yields will move higher.

So far, the market hasn’t had a tantrum like I mentioned earlier, and the Fed is hoping to avoid a market overreaction by using its preferred tool: talking.

A number of Fed officials have been testing the markets by talking up the intention to taper reinvestment in the balance sheet and to keep hiking rates as planned.

Fed Vice Chairman Stanley Fischer thinks that since the market didn’t react much to the minutes (that mentioned the taper), that it’s less likely we will face major market disturbances.

Kansas City Federal Reserve Bank President Esther George, in a March interview with Bloomberg, mentioned she’s in favor of normalizing rates and the balance sheet this year as long as the economy is healthy enough to do so.

According to the Financial Times, Boston Fed President Eric Rosengren said he’s prepared to begin the process of reducing the balance sheet and gradually normalization of rates.

I’m not sure if the market’s ignoring the Fed since rates haven’t reacted much or because the rest of the world (including the Bank of Japan (BOJ) and the European Central Bank (ECB)) is still increasing its purchases. Since 2008, the ECB more than doubled its balance sheet, while the BOJ has more than tripled its own. The Fed’s balance sheet has quintupled in that period, so maybe the markets think foreign purchases will continue for a while.

In any case, the Fed will have $426 billion in Treasurys mature in 2018 and $357 billion in 2019. That’s going to be a lot for the market to absorb if the Fed stops reinvesting.

But it’ll be a heck of a gift to the U.S. Treasury!

When the Fed finally starts reducing its monstrous balance sheet, market volatility will spike, and that’s good for Treasury Profits Accelerator readers!

We make money when the Treasury bond markets overreact!

Good investing,

Lance Gaitan
Editor, Treasury Profits Accelerator

What Killed the Middle Class?

Today real incomes of the middle class are 5% lower than they were in 1970 and 12.4% lower than in 2000… when they peaked! How could this be?

In our new infographic What Killed the Middle Class?, we take a look at some shocking numbers to show how bad it’s become and what has been fueling this middle-class revolt.

 

LEARN MORE
Categories: Central Banks

About Author

Lance Gaitan graduated from Franklin University in Columbus, OH with a degree in Finance. After graduating and working as an auditor for an insurance administrator as a number of years, he attained his securities license. He then went to work as a broker for a small firm and during the mid-1990’s Lance managed the futures trading desk for Piper Jaffray, a large regional brokerage firm based in Minneapolis. After migrating to Florida in early 2000, Lance founded a futures trading firm, GSV Futures, specializing in retail commodity trading strategies. Lance sold that business in 2006 and joined Harry Dent, Jr. and Rodney Johnson at Dent Research shortly thereafter.