Friday, August 11, 2017

Getting Normal Again

Imagine a tsunami of corn, for example, being dumped on the market.  The value of corn per bushel would plummet because supply greatly exceeded the demand for corn.  That is one of the worries overhanging the bond market right now.  The Fed could release a tsunami of government bonds on the bond market IF they suddenly reduced their balance sheet to a more normal level.  And, what happens when the value of bonds drop?  Interest rates are forced up, in order to be competitive and sell the bonds.

When the global financial crisis began in 2008, the Fed's balance sheet was only about $800 billion, roughly the amount of currency-in-circulation.  Then, there was quantitative easing I (QE1), followed by quantitative easing II (QE2) and quantitative easing III (QE3).  By then, their balance sheet had swollen to an astronomical $4.5 TRILLION.  They had acquired the $2.7 trillion of bonds issued by the Federal government to fund the massive deficit spending during the global financial crisis, as well as another $1.8 trillion of mortgage bonds to keep interest rates low on home mortgages, supporting the huge housing market.

If the Fed sold all $4.5 trillion of bonds suddenly, the bond market would certainly crash, taking the stock market down with it.  This is NOT news, and there is no chance the Fed will actually do this.  However, the Fed must start normalizing its balance sheet at some point.  Their plan is to start selling  about $10 billion per month and to increase that amount quarterly.  If the market cannot handle that, the Fed will stop the selling, but I'm confident it can handle a relatively modest amount like that.

The Fed said they might begin late this year but is more likely to begin next year.  It is expected to take about five years to get the balance sheet down to the $1.5 - 2.0 trillion, which would again be about the level of currency in circulation.

It is going to happen.  The amounts will be modest.  It can be stopped at any time.  Still, the market is quite worried about it.  I'm not!