Beginning in the later months of 2008 the U.S. Federal Reserve Bank (FED) began to expand their balance sheet, which at that time was in the range of $800 billion. Over the next 5+ years, 3 quantitative easing programs, where the FED bought U.S. Treasury Securities and government guaranteed Mortgage Backed Securities in the open markets, exploded the size of the FED balance sheet to over $4.2 trillion, close to where it is today.
It is widely thought that the FED would like to reduce the size of their balance sheet to somewhere in the $2 trillion range in coming years. The question is how quickly should the FED reduce the size of their balance sheet and what effect will that have on prices in the various securities markets. Conventional wisdom indicates that if the FED were to reduce their balance sheet over a similar 5+ year time frame interest rates could return to levels seen prior to 2008. In other words, closer to 3% short term rates and 4%-5% longer term treasury rates. While this would be in line with the interest rate outlook indicated recently by FED members, it would be, in our opinion, an overly aggressive balance sheet reduction program.
A more likely program would involve the reduction of the balance sheet over a longer time frame with the hope that any impact on interest rates and securities valuations would be minimal. As is typical we expect “well hedged” comments by the FED on this subject and commentary such as “our reduction of the size of the balance sheet will be data dependent and thus the timing of this program could change”.
So why does this balance sheet reduction announcement matter so much to the various securities markets? The principle “commodity cost” of the securities markets is the cost of money/level of interest rates. When investors can borrow at very low rates even modest returns can produce sizable returns, especially in leveraged portfolios. When interest rates are higher (or at more historically average levels) fixed income investments become a more viable alternative to higher risk equities, commodities, etc., and it becomes more difficult to earn returns well above these lower risk securities. This in turn may lead certain investors to demand better/lower valuations in order to risk their capital.
Jim Bernard, CFA, is the Managing Director, Fixed Income at Ancora Advisors LLC a SEC Registered Investment Advisor. He is also a Registered Representative and Registered Principal of Inverness Securities, LLC. (Member, FINRA/SIPC)
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