1. Fed to Reduce Massive $4.5 Trillion Balance Sheet – Implications
2. How the Fed Got to $4.5 Trillion & Is There a Way Out?
3. Fed Announces Controversial Plan to Reduce Its Balance Sheet
4. Unwind Timeline & Implications For the Markets & Economy
5. Conclusions: Markets Don’t Like Uncertainty

Fed to Reduce Massive $4.5 Trillion Balance Sheet – Implications

Most investors understand the implications of the Fed raising (or lowering) interest rates. After lowering short-term interest rates to near zero in late 2008, and keeping them there for eight years, the Fed is now committed to “normalizing” short-term rates by raising the key Fed Funds rate multiple times over the next couple of years.

Starting back in March, and more specifically at the May meeting, the Fed also began to talk about reducing the size of its “balance sheet” which today consists of apprx. $4.5 trillion in US Treasury bonds and mortgage-backed securities. My impression is that many investors don’t fully understand what reducing the balance sheet entails, but it is very important. I’ll try to explain it and the market implications as we go along today.

Let’s begin by going back to 2007 before the financial crisis and the Great Recession unfolded. In late 2007, the Fed Funds rate was above 5% – before the Fed embarked on its Zero Interest Rate Policy (ZIRP). Within about a year, the Fed slashed its key short-term rate to near zero and kept it there until late 2016 when it began increasing it.

Federal Funds Rate

In addition to raising and lowering short-term interest rates, the Fed can also increase or decrease its balance sheet of assets and liabilities. Since the Fed has the ability to “create money,” it can increase its balance sheet by virtually unlimited amounts.

To increase its balance sheet, the Fed has in recent years ballooned its purchases of US Treasury bonds and mortgage-backed securities. These purchases were intended to keep longer-term interest rates low and hopefully boost the economy.

In 2007, the Fed’s balance sheet consisted of apprx. $800 billion of mostly Treasury bonds and to a much lesser extent mortgage-backed securities. Sounds huge, right? Yet since then, the Fed’s balance sheet has exploded to apprx. $4.5 trillion, which is nothing short of mind-boggling! Now the Fed says it wants to begin reducing this mountain of debt.

As I will explain below, I fear that this unwinding of the Fed’s balance sheet has much more serious implications for the US economy than the planned increases in the Fed Funds rate.

If the Fed gets this so-called “unwind” wrong, the fallout could be dramatic, including a sharp rise in interest rates, tumult in the stock and bond markets and maybe the next recession.

This is why ALL serious investors need to understand what the Fed is about to undertake.

How the Fed Got to $4.5 Trillion & Is There a Way Out?

I like the way CNBC columnist Jeff Cox introduced this topic to his audience recently:

“Consider the Federal Reserve the Starship Enterprise of monetary policy: It went where no central bank had gone before, and now must plot the journey home.”