Ignore At Your Peril

They’re at it again. It isn’t enough that the Federal Reserve’s tighter monetary policies are hamstringing global economic growth, but over the past week a few different Fed officials floated the idea of reducing the size of the Fed’s balance sheet. They seem intent on tightening until something breaks.

I have long argued Janet Yellen’s Fed is way more hawkish than most pundits believe (Janet’s Bullshit). Ever since assuming the role of Chairperson on February 3rd, 2014, Yellen has presided over a policy of tightening monetary policy through tapering of quantitative easing, then fully stopping Fed balance sheet expansion, and finally raising rates. The net effect of this tighter policy is a rip roaring US dollar, along with higher short rates and a flattening yield curve.


Not content to merely raise rates, Fed officials appear to be preparing the market for actual balance sheet reductions in the coming months. Last week several different Fed officials took the opportunity to highlight the possibility of the Fed abandoning their policy of reinvesting proceeds.

From Marketwatch:

The Federal Reserve “may be in a better position” to reduce the size of its balance sheet now that it has raised interest rates twice in the past year, St. Louis Fed President James Bullard said Thursday.

In a speech to the Forecasters Club of New York, Bullard said the Fed may be able to use its balance sheet as a way to tighten monetary policy without putting exclusive emphasis on higher interest rates.

From the FT:

The Federal Reserve should be ready to consider reducing the size of its balance sheet as part of its efforts to prevent overheating in the US, a senior policymaker said as he noted the pick-up in wage inflation and predicted a return of inflation to target by the end of the year.

Eric Rosengren, the president of the Federal Reserve Bank of Boston, said that if the Fed is in a position to lift rates with “more alacrity” than the one-a-year pace of rate rises seen in the past two years, then officials should be willing to debate reductions in the size of its huge asset portfolio.

“We should be considering it now, and at what point the committee actually decides to take action we will have to see,” he said in a telephone interview with the Financial Times. “But my own criteria would be if we think the economy is strong enough that we are going to need to do multiple tightenings . . . at that time we should be seriously thinking about reducing the balance sheet.”

From Reuters:

The Federal Reserve can consider shrinking its massive trove of bonds once the interest rate on overnight lending between banks rises to 1 percent, Philadelphia Fed President Patrick Harker said on Thursday.

“When we are at or above 100 basis points – and we are moving toward that – I think it is time to start serious consideration of first stopping reinvestment and then over a period of time unwinding the balance sheet,” Harker, who has a vote on monetary policy this year, told reporters. He was referring to the fed funds rate for interbank lending which the central bank tries to guide.

You would need the intelligence and myopicness of a reality TV star to miss the signal the Fed is sending. There is no doubt the Federal Reserve is preparing the market for an unwinding of their balance sheet.

Most likely the Fed will not outright sell bonds, but stopping the re-investing of maturing issues will have the same effect.

So far the market reaction to the news has been fairly subdued. Stocks have for all intents and purposes ignored it, and US bonds had a bad couple of days before stabilizing.

I think this is a big mistake. The Fed is already too tight, and this potential unwinding of the balance sheet is a much more significant development than most market pundits realize.

Although Trumphoria continues to cloud the bulls’ minds with psychedelic hallucinations of unrealistic economic outcomes, there will reach a point when the drug wears off, and market participations will once again be forced to deal with the cold economic reality of the current situation.

And at that point, the Fed’s hawkishness will become fully apparent.

Many economists believed the Fed would never be able to wind down their balance sheet. Many assumed the expansion of the past eight years was permanent.

Now the Fed is telling us this is not the case, and they will give winding it down a whirl.

Yet the stock market is forgetting how we got here.


In the days following the Fed’s 2008 announcement of the first quantitative easing program the stock market did not initially jump higher. Stocks kept declining as the market did not fully understand the scope of the Fed’s program.

Even in the following years as the Fed kept expanding their balance sheet, and the relationship between the stock market rise and the QE programs was becoming more obvious, most market participants kept assuming the stock market would resume its decline.


The size of the Fed’s balance sheet was probably the most important determinant of the stock market level during this period.

At the time most hedge funds managers were hyperventilating about the ultimate decline when the Fed stopped expanding their balance sheet. But here we are with the Fed contemplating actually reducing it, yet most hedge funds are all bulled up on stocks and ignoring the Fed’s rhetoric.

Well, I am not ignoring it. And I don’t buy that the relationship between the Fed’s balance sheet and the stock market level should be tossed out the window.

The Fed reducing the size of their balance sheet is a big deal. Ignore it at your peril.

Thanks for reading,
Kevin Muir
the MacroTourist