When the Federal Reserve’s Federal Open Market Committee (FOMC) meeting is over today, whatever the determining body’s interest rate policy statement says about a rate hike (or how much they’ll hike, or how many hikes to expect, or whatever Fed Chair Janet Yellen says in her press conference after the two-day meeting’s over), there’s only one word that matters to investors.
That word is “run.”
Fed officials, including the Chair herself and a few Regional Fed Bank presidents, have gingerly been putting the word out there for months now.
In “Fed-speak”, the mumbo-jumbo they love to throw around, the word ‘run’ has a few meanings. There are four different ways they could potentially use this word to change the course of markets dramatically.
A Quarter of a Percentage Point
Almost everyone expects the Fed to raise the federal funds rate, the rate big banks charge each other to borrow money overnight. Fed funds futures, based on the price for the front-month contract, suggest an almost 90% chance of a hike of 0.25% or, in Fed-speak, 25 basis points.
That’s no biggie. If we get a 25-basis point hike, the federal funds rate will only be between .75% and 1%.
Historically, the average fed funds rate has been 3%, with the normal range being between 2%-5%.
There are plenty of reasons the Fed will likely raise rates today, and there aren’t any reasons not to.
The Fed’s been shooting at a 2% inflation rate, a level they say would break the deflationary cycle they’ve been battling. Depending on which measure you use and how you calculate it, we’re already there. Fed officials prefer the personal consumption expenditure (PCE) deflator, a measure of goods and services targeted towards individuals and consumed by individuals, when other measures like CPI (consumer price index) are already at 2%. Since both are close enough, that’s one reason to hike.
But inflation isn’t an island. It’s looked at through the prism of jobs growth, the unemployment rate, and wages, and right now two of those three metrics certainly point to a rate hike.
February saw an increase of 235,000 jobs, continuing a very positive trend for jobs growth. The unemployment rate is now 4.7%, which historical norms consider the “structural” rate of full employment. The last piece of the inflation trifecta is wages. Though they aren’t growing yet, with more people working, the expectation is wages will start rising. That worries the Fed, and thus warrants a hike.
Bond prices are holding steady after they rose slightly at the prospect of a rate hike.
The stock market’s been on a monumental tear, making successive new highs.
Global markets have firmed up and have been rising as growth prospects show signs of “green shoots.”
There’s no reason not to hike a quarter of a percent.
I’m betting the Fed’s going to hike. The market’s betting the same way. Almost everyone is.
The only thing to worry about is the word “run.”
Depending on if, or how, the Fed incorporates the word run (with its multiple conjunctions), matters to investors.
4 Ways to Run
The operative iterations of run are:
- run rate
- short run
- long run
And it’s all about the Fed’s balance sheet.
Prior to the financial crisis, the Fed’s balance sheet (the ledger where it shows its “assets”) totaled just shy of $900 billion. Today, it’s $4.5 trillion.
That means the Fed bought more than $3.5 trillion worth of Treasuries, agency paper, and government-guaranteed mortgage-backed securities since the financial crisis started.
Of course, they earn interest on the bonds they bought. Their run rate, in terms of the earnings they derive from their assets, is about $100 billion a year.
That’s a lot of money.
The Fed doesn’t keep that. It forks it over to the Treasury. That’s the deal it made when it created itself and sold its services to the U.S. government back in 1913, when it was legislated into existence. But that’s another story.
What’s important now is that run rate, because the “little” amount the Treasury gets could change if the Fed lets the assets on its balance sheet runoff… but that’s not the half of balance sheet runoff.
Runoff means the Fed lets the bonds it bought mature. At maturity, bonds cease to pay interest and the principal used to buy them is returned to the buyer. That would be the Fed.
But the Fed didn’t have the capital to actually pay for the bonds it bought. It “prints” the money it needs, or, in accounting terms, checks a credit box on the Treasury’s or some bank’s electronic balance sheet that gives the Treasury/bank it buys bonds from the right to use that credit as actual money. So the Fed just crosses off the credit it gave out as being returned.
There’s no reason for the Fed to sell any of the bonds it holds. To do so – especially because of the huge quantities it owns – would depress prices since banks and private investors would have to buy them.
When it comes to the Fed “normalizing” interest rates, it can hike rates (like it plans on doing today), or it can decide to not buy any more bonds while the bonds on their balance sheet runoff… Or it can do both.
Right now, and for supposedly the foreseeable future, when bonds the Fed owns run off or mature, they take the credit they get back and buy an equivalent amount of new bonds to offset the bonds that matured. That’s why their balance sheet hasn’t changed.
What’s important for investors to listen for is any talk about letting the balance sheet runoff. This would mean the Fed would, at some point, stop replacing maturing bonds and let their balance sheet run down instead of continuing to buy new bonds to replace maturing bonds.
Forecasting a runoff is tantamount to tightening.
If the Fed isn’t buying bonds on a regular basis, it isn’t there supporting market prices and interest rates could and probably would rise.
In the long run, the Fed will let bonds runoff. However, in the short run, the pace at which the Fed allows any runoff and what maturity bonds or notes or bills it buys to replace maturing bonds will determine the direction of interest rates.
Right now the average maturity of the Fed’s holdings is about six years. Every time the Treasury sells bills, notes, and bonds at auctions, the Fed buys what they need at those auctions. This is in proportion to what the auctions are selling in different maturities, to offset the amount of money that runs off their balance sheet before the next auction. That way, the Fed’s average maturity can change.
However, if the Fed wants to tighten and not directly raise the fed funds rate, it can choose to selectively buy shorter term bills or notes at upcoming auctions.
They’d buy short maturity paper to let them runoff sooner when they mature, which would lower the average maturity of their balance sheet holdings, letting big-picture runoff happen sooner. This would “normalize” rates sooner so that they don’t get hurt holding longer maturity bonds when rates rise, which could result in a capital loss on their balance sheet. Even though they aren’t selling bonds, but plant to hold them to maturity, the last thing the Fed wants is to look like it’s losing money.
Investors are going to have to start parsing Fed minutes for the word run from now on.
If you don’t know what they mean when they’re talking about run rates, runoffs, short run, or long run… you’re going to learn the hard way markets don’t like what the wrong kind of run can do.