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A Deeper Look into the Fed’s Balancing Act Reveals What They’ll Announce Today

3 | By Shah Gilani

Here we go again. Another Fed meeting, another round of handwringing over how markets will react.

It doesn’t have to be that way. While there are three possible market reactions to what I expect the Fed to say and do, there are only two probable outcomes for markets.

And in the end, they’re the same.

This time around, the Fed’s going to address the two big issues everyone’s questioning:

  1. When are they going to raise rates again?
  2. When are they going to start reducing their balance sheet holdings?

Here’s what the Fed’s likely to do, and how markets will react…

How the Fed Found Itself Caught in the Balance

Let’s start with the Fed’s balance sheet.

The Fed will likely announce it’s going to start letting its balance sheet run off (if it hasn’t run off already) because there isn’t a good enough reason to hold it up.  The other possibility (as no one else seems to consider), is the Fed shortening the maturity of its holdings as a prelude to reducing its balance sheet.

The Fed needed to alleviate inordinate pressure big banks faced during the financial crisis. That pressure came from holding securities that were collapsing in value, rendering them technically insolvent. To accomplish this and drive interest rates down (specifically the federal funds rate), the Fed bought trillions of dollars’ worth of government and agency mortgage-backed securities and Treasury bills, notes, and bonds to rally prices and flush the financial system with massive doses of liquidity.

That’s how the Fed ended up holding $4.4 trillion in securities on its balance sheet.

With big banks flush with profits for some time now, the housing market long since back to where it was before the crisis, and financial markets around the world notching all-time highs, there hasn’t been a need for the Fed to hold such a massive amount of inventory for years.

Today, the Fed will announce some kind of plan to unwind its balance sheet.

All that means is, instead of buying more securities to replace bills, notes, and bonds that mature out of their inventory, it’ll just let them run off and not replace them.

Of course, it’s unlikely the Fed will ever commit to any set path for doing anything. It’ll announce its intentions to reduce the balance sheet and calm markets by saying something to the effect that the unwinding program will be “data dependent,” and it will mean that the Fed will unwind as it sees fit.

As far as raising rates, there’s absolutely no reason for the Fed to leave the funds rate idle. There’s also no reason to raise them any less than another 25 basis points. In non-technical terms, that’s another quarter of one percent.

What matters most and what will affect markets in the immediate future, is when it makes that 25-basis-point jump.

3 Ways the Market Could React (and Why It Doesn’t Matter)

Announcing a rate hike today is a possibility, but not likely.

Markets aren’t expecting an immediate rate hike, but they are looking for a hike in December. Since the Fed’s mission has been to calm and coddle financial markets for the past nine years, there’s no reason to upend them with a surprise announcement today. Telegraphing a likely rate hike in December just makes more market sense.

Announcing the beginning of its balance sheet unwind and expectation for a hike in December could impact the stock market in three ways:

  1. It could sell off.
  2. It could drift sideways for some time.
  3. It could keep on rallying.

It’s unlikely the market will drift sideways for very long since there’s so much capital at risk and even more capital still on the sidelines.

Bold pronouncements on unwinding and hiking from the Fed, especially if it admits inflation is ticking up (which it is by every measure), could cause a round of profit-taking. If that were accompanied by rising geo-political tensions, that profit-taking could turn into a minor correction.

Then again, markets could shrug off any hawkishness by the Fed, as they’ve shrugged off every other market threat lately, and keep on rallying.

Even if we get a selloff, it will likely be short-lived. Markets will head higher on news of possible tax cuts, news of the President working with Democrats to get Congress to act on anything positive for the economy, or news of tensions with North Korea ratcheting down.

The reasons why I expect markets to continue higher, even if we get a selloff, are the same reasons why the Fed will start to unwind and raise rates.

All Things Considered, We’re Still Headed Higher

U.S. stock markets, no matter which index or market measure you choose, are at or just below all-time highs.

The ISM (Institute for Supply Management) manufacturing reading for early September came in at 58.8, up from 56.3, with all-important “new orders” at 60.3. The non-manufacturing index rose to 55.3 from 53.9, with new orders up to 57.1 from 55.1.

Sentiment and optimism are rising. Even the National Federation of Independent Businesses’ small business optimism survey is at an all-time high.

Global markets have been rallying too.

If September ends up being a positive month for global markets, it will mark the 11th straight month of gains for all 45 of the OECD’s largest economies. That hasn’t happened since 2003-2004.

The Organization for Economic Cooperation and Development expects markets to continue to rise throughout 2018. It’s been 10 years since the big OECD economies saw back-to-back years of rising equity markets.

97% of OECD countries have PMI index readings greater than 50, which indicates expansion.

Those are all positive momentum factors for domestic and global economic growth and markets.

Lastly, there’s the dollar. It’s down 10% this year against a basket of major global currencies.

Unwinding the Fed’s balance sheet and raising rates will put upward pressure on the dollar. But there’s plenty of room for the dollar to bounce off its recent lows and not negatively impact earnings of U.S. multinationals and giant tech companies, which have enjoyed double-digit earnings growth partly because of the lower dollar.

While equity markets and economic growth (both globally and in the U.S.) enjoy positive momentum, it is the perfect time for the Fed to start “normalizing” its bloated balance sheet and raising artificially manipulated low rates,.

They will start today, and markets will adjust accordingly.

And, based on how they’ve been reacting lately, that means they’re heading higher.

Sincerely,

Shah

3 Responses to A Deeper Look into the Fed’s Balancing Act Reveals What They’ll Announce Today

  1. Conrad Lauer says:

    You use “market/s” as if these constructs had a personality. Isn’t it that they reflect the sum of all hopes and fears of all market participants?

    Morgenstern

  2. fallingman says:

    The Fed is a criminal, treasonous enterprise. Let’s never forget that as we consider what criminal act they’ll commit next or as we parse their latest Delphic forward guidance and its likely effect on the markets.

    We never talk about the mafia without noting their criminal nature. Why does the Fed get a free pass? They’re infinitely more destructive to the fabric of society, enabling their rapacious bankster owners to get away with financial murder and stealing money from savers just as surely as if they’d held them up at gunpoint.

  3. Marie Antoinette says:

    My Dear Mr. Gilani,
    I just “read” that the US debt n.o.w. exceeds the GDP! In other words, in ’96, the national debt was about 63%… and n.o.w. the debt exceeds 100%. Time for the executions? I will spend the next 6 months learning about spreads, so that I may pass my level 2 inquisition, when my options exam window opens again in the Spring. Ciao.

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