Nine years after the start of a quantitative easing program that left the Federal Reserve with a record $4.5 trillion balance sheet, market watchers are now speculating how the Fed’s plans to start selling those bonds will hit the financial markets.

While forecasts on the full impact of an unwinding program that could start as early as September are all over the map, most observers agree it is likely to ripple across most segments of the financial markets.

“They have a humongous task ahead of them, and there is no formula for this,” said Bob Rice, chief investment strategist at Tangent Capital. “There are chances for unexpected surprises, because there’s no telling what it will do to mortgage rates, and you will see a return of market volatility.

“The most important point is that this unwinding is a really big deal and people have gotten numb to extraordinary Fed action, but this has the potential to cause peculiar market reactions,” he said.

The three rounds of Fed bond buying, which grew the Fed’s balance sheet nearly six-fold between November 2008 and October 2014, is so unique there are concerns that the unwinding will be felt across both the stock and bond markets.

“The ultimate impact is not even conclusive on the interest-rate side of things, because some people say it will cause rates to go up and others think it will cause rates to go down,” said Crit Thomas, global market strategist at Touchstone Investments.

Economic logic suggests that interest rates will rise as the Fed starts selling bonds into the market. But as Mr. Thomas pointed out, when the Fed was in the throes of its bond-buying binge, the yield on the 10-year Treasury bond was climbing in stride.

“The thought is, they were flooding the market with stimulus, so maybe taking that stimulus away will push rates down,” he said. “But I think people are worrying about the wrong market, because it’s really equities where you should be more concerned. There was a stock market rally during each QE event, so I’m more concerned with the stock market pulling back as the Fed starts to unwind.”

The Fed’s current balance sheet, made up of $2.7 trillion in Treasury bonds and $1.8 billion in mortgage-backed securities, was built up in the wake of the 2008 financial crisis as a means of boosting economic activity when it became clear that dropping interest rates to zero was not enough.

At the start of the $1.75 trillion first round of Fed bond buying between November 2008 and March 2010, the Fed owned just $800 billion worth of bonds, which was about equal to the amount of currency in circulation at that time.

Round two of QE, between November 2010 and June 2011, added another $600 billion to the Fed’s portfolio.

And round three, between September 2012 and October 2014, added another $1.64 trillion.

The Fed’s plan is to initially sell about $6 billion worth of Treasury bonds and $4 billion worth of mortgage-backed securities per month, and gradually increase the amount it sells every three months.

It is expected to take between three and five years to get the Fed’s portfolio down to the targeted $2 trillion range, which would be equal to the amount of currency in circulation.

The unwinding could be particularly hard on the mortgage market, considering the Fed currently owns about 20% of the MBS market.

“We believe the Fed’s unwinding will likely have a bigger negative impact on mortgage-backed securities,” said Rick Keller, chairman of First Foundation.

“A lot of mortgage-backed securities are held by banks to meet liquidity requirements imposed on them by regulators,” he said. “I think many of these investors are likely to sell into rising rates to avoid taking the possible loss on their balance sheet and to avoid further price reductions.”

Matt Lloyd, chief investment strategist at Advisors Asset Management, believes the unwinding process will drive interest rates higher, which would also help create some yield separation between shorter- and longer-dated bonds.

“Right now the yield curve is flat, and that allows the Fed to accelerate the unwinding at a quicker pace,” he said. “I do think bond yields will move higher, but that’s okay because it will help steepen the yield curve.”

Mr. Lloyd also believes the unwinding process will increase volatility across the equity markets, but he doesn’t think the volatility will be enough to derail the upward potential of stocks.

“You will want to be buying on the dips during this unwinding,” he said.

Of course, not everyone is so certain the market dips will be just that.

The unwinding “is a market mover and an economic mover,” said Leon LaBrecque, managing partner and chief executive of LJPR Financial Advisors, which manages $707 million in client assets.

“As the Fed’s balance sheet unwinds, the cheap money dries up and companies will have to do more than the riskless share buy-backs,” he said. “It’s silly to think the unloading of trillions worth of bonds will have no effect.”

Article published by Investment News July 17 2017

Written by Jeff Benjamin