Is the Great Unwind Approaching?

Nick Burwell | Portfolio Manager

Even occasional financial market observers have become familiar with the term quantitative easing. This unconventional monetary policy tool, in which central banks buy government securities in order to drive interest rates lower and increase money supply has clearly had a profound effect on the price of all types of assets. It is impossible to know where this economy and the stock, bond, real estate and labor markets would be without this unprecedented intervention. I can hardly recall a discussion centered around markets that did not include at least a mention of the all-powerful QE. Personally, I believe rates have been kept too low for too long. But like everyone else, I’m just plain tired of speculating as to what the final outcome will bring. Of course, there is some bias here, as some of us dream of the day we can pick up 4-5% yielding bonds with short maturities and solid credit fundamentals. The $64,000 question that we face today is, Can the Fed actually reverse some of this stimulus and will this potentially give us the attractive bond yields the world so desperately craves?

At the last Federal Open Market Committee meeting, the board released something called the “Addendum to the Policy Normalization Principles and Plans”—essentially a process to reduce the size of its $4.5 trillion stockpile of Treasury, Agency and mortgage-backed securities. The committee has hinted it would like to begin this process this year but has not set a formal date. The general idea is that the committee will gradually stop reinvesting principle payments as the securities it holds reach maturity. They will initially cap this amount at $6 billion per month for Treasuries and will increase in steps of $6 billion every three months until the cap maxes out at $30 billion per month. For its Agency and mortgage-backed securities, the committee will start with a $4 billion cap, increasing every 3 months until it reaches $20 billion per month. The addendum goes on to point out, “the Committee would be prepared to resume reinvestment of principal payments received on securities held by the Federal Reserve if a material deterioration in the economic outlook were to warrant a sizable reduction in the Committee’s target for the federal funds rate.”

For now, we still have Europe and Japan instituting massive quantitative easing programs but in the case of Europe at least, as the economy there continues to show signs of life, many market participants are expecting an announcement this fall detailing plans to taper European QE mid-year 2018.

So what will the future hold once the QE lever is pulled the other way? Hard to say for sure, of course. We continue to keep our interest rate risk defensively positioned against the broad index. We do expect, however, interest rate volatility to pick up in the coming months and will continue to pursue trading opportunities along the way.

An important key to this grand plan to unwind the Fed’s balance sheet will be the time factor remaining for the current economic expansion. The history book is far from written regarding the post-financial crises central bank QE episode. Some say all the money printing creates perverse incentives and misallocation of capital. Some say it indiscriminately punishes savers of financial capital. And then there are those who think this program saved us from an economic environment rivaled only by the Great Depression of the 1930s. Whether or not the monetary authorities can successfully pull off the reverse side of this grand experiment will have implications for future generations of worker bees all across the globe for years to come.

To be continued…

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