A Small (and Short) Amount of Common Cents for May 4, 2018

May 4, 2018, by John Norris

This past Monday afternoon, I told a group of Oakworth associates the major stories this week would be the FOMC meeting/statement on Wednesday and today’s Employment Situation report. Although neither so-called big event was terribly surprising, sometimes simply ‘getting it over with,’ whatever it may be, is more important than anything else.

As I type here on Friday, May 04, 2018, much is as it was and has been for a while. The Fed will likely raise the overnight lending target by 0.25% at the June and September meetings. The economy is growing a slightly better than mediocre clip, most folks who really want a job have one, and the biggest threat to the US economy remains the Federal Reserve. Psst….it normally is.

As the Four Tops once sang: “Somebody shake me, wake me, when it’s over.”

While everyone has an inkling what the Fed will do with the overnight rate for the remainder of 2018, I feel the bigger question is: how rapidly will the Federal Reserve shrink its bloated balance sheet (thanks to quantitative easing), thereby sucking liquidity out of the economy? Oh, we think we have a decent idea. After all, ‘they’ have given us a timeline and all of that. But is it sacrosanct?

Make no mistake about it: the Federal Reserve flooded the financial system with liquidity in the wake of the Financial Crisis. More than anything else, this excess cash (if you will) was the prevailing tailwind for the US stock market for, quite literally, years. So, what happens when the Fed starts taking it out?

Right now, this is anyone’s best guess, because the scope of the quantitative easing programs during peacetime was unprecedented. So, we don’t really have past experience to help shed light on the future, just intuition. What does that tell us?

For, again, years, the Fed was basically a backstop for the bond market, putting a de facto ceiling on interest rates by gobbling up sizable chunks of Treasury/Agency debt and MBS each month. By the time the smoke cleared and dust settled, it had increased its balance sheet by trillions of dollars, with a T. Obviously, that is a lot of money, and the Fed is taking it away some $30 billion per month at a time.

Clearly, that amount per month won’t shrink the Fed’s balance sheet in a meaningful way for a long period of time. That isn’t the issue. Nope. The issue is the Fed had been ‘putting’ $60 billion into the system each month, and is now taking $30 billion out. That is a $90 billion swing, which is a little more meaningful. Pair this with a couple more overnight rate hikes, and what do you have?

To put that number into perspective, $90 billion is roughly the size of Hawaii’s Gross Domestic Product. Hmm. I can’t imagine the end result will be robust growth and expanding stock market multiples. That just doesn’t compute.

Okay…I tried to write the reason why this doesn’t compute in a coherent sentence, and it was a mess, just awful. Heck, I could barely understand it. So, here are some bullet points which should make things a little more understandable.

  • There is an inverse relationship between interest rates and bond prices. When prices go up, interest rates go down and vice versa.
  • During the quantitative easing programs, the Fed was buying debt securities, arguably driving up the price of the things higher than what it would have been without the intervention.
  • Intuitive, the quantitative easing led to lower interest rates, at least lower than what we would have had otherwise. As such, you could sensibly argue the Fed ‘artificially’ lowered interest rates in the US.
  • Lower interest rates on bonds can make stocks look more attractive as an alternative investment. This means investors could have opted for a higher stock allocation than they would have ordinarily.
  • When the Fed shrinks its balance sheet, it sells debt securities back to the markets and effectively retires the cash.
  • Since the Fed had been the backstop AND is now selling, will there be enough private sector demand to keep interest rates reasonably ‘in check.’ Or will the triple whammy of: 1) likely lower tax receipts in 2018; 2) potentially higher Federal spending meaning more borrowing (read supply), and; 3) the Fed ‘selling into’ a supply heavy market lead to significantly higher interest rates.
  • IF that happens, at what point do bonds become more attractive to investors, thereby sucking money out of the stock market? Causing prices and multiples (more than likely) to fall.
  • After all, that is what multiples do in a rising interest rate environment.
  • Will the upcoming increase in Federal debt offset the shrinkage in the Fed’s balance sheet, at least in terms of cash sloshing about the financial system in some form or fashion? Will it swamp it, driving up interest rates in the process?

This is the type of stuff I have floating around in my head.

While all of this important, the truth of the matter is decidedly less intellectually, um, stimulating. In a recent letter I sent to clients, I shared the following (after a particularly bad day in the stock market):

More or less simply put: 1) the economic data is reasonable; 2) the yield curve is still positively sloped; 3) corporate earnings have been pretty good, all things considered; 4) inflation is still pretty tame by historical measures; 5) leading indicators are positive; 6) non-performing loans at banks are at low absolute and relative levels, and; 7) business optimism remains robust. These are not your normal ingredients for an economic/market collapse.

Yep, that pretty much sums it up nicely.

At the end of the day, at the end of this week, nothing has really changed all that much. We had some big stories and reports which didn’t surprise anyone, and the news headlines are still as shrill as ever. When historians look back on this week, with all the anxiety and meaty economic events, they will note: the S&P 500 was down 0.21% and the yield to maturity on the 10-Year US Treasury fell 0.01%.

That should put all of the mental gymnastics I did in this piece into perspective.