Joe Preisser, Portfolio Specialist, Brinker Capital
The winds of change have begun to blow through Washington, D.C. carrying with them whispers that the Federal Reserve Bank of the United States is contemplating a more immediate slowing of the unprecedented stimulus measures it has employed since the financial crisis than many analysts anticipate, which could have broad implications across the global landscape. Several signals have been offered by the American Central Bank in the past few weeks to prepare the marketplace for the impending reduction of their involvement, highlighting the delicate nature of this endeavor.
The Institution faces a daunting challenge in trying to scale back a program that has largely been credited with fueling a dramatic rise in asset prices, without interrupting the current rally in equity markets. Although the U.S. economy has shown itself to be growing at a moderate pace, a measure of uncertainty lingers within investors as to whether this growth is robust enough to compensate for the paring back of the Bank’s historically unprecedented accommodative monetary policies.
As the depths of the ‘Great Recession’ threatened to pull the global economy into depression, the U.S. Central Bank undertook a herculean effort to bring the country back from the precipice of disaster. The tangible result of these efforts has been a deluge of liquidity forced upon the marketplace, which has given birth to a tremendous rally in share prices of companies listed around the globe, and helped to repair much of the damage inflicted by the crisis. The dramatic expansion of the Fed’s balance sheet, since the inception of these programs, has culminated in the most recent iteration of these efforts—an open-ended program of quantitative easing, comprised of the purchase of $45 billion per month in longer dated U.S. Treasury debt and $40 billion of agency mortgage-backed securities, undertaken in September of last year, that has brought the aggregate amount of assets acquired by the Bank to more than $3 trillion.
The chart above depicts the increase in the size of the Fed’s balance sheet (white line) versus the S&P 500 Index (yellow line).
As the economic recovery has gained momentum in the United States, with notable improvements seen in both the labor and housing markets, concern has been voiced that the flood of liquidity flowing from Washington should be tapered, lest it potentially result in the creation of artificial asset bubbles, which in turn could present risks to price stability.
The first broach of the possibility of the Fed varying the additions it is making to its balance sheet came in a press release from the Federal Open Market Committee on May 1 which stated that, “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” This statement was followed by the May 11th publication of an article authored by Jon Hilsenrath of the Wall Street Journal, who is widely considered to be a de facto mouthpiece for the Central Bank, “officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves. The timing on when to start is still being debated” (Wall Street Journal). Comments issued on Thursday by the President of the San Francisco Fed, John William’s, referred once again to the possibility of the Central Bank’s program being scaled back, potentially sooner than many market participants anticipate, “It’s clear that the labor market has improved since September. We could reduce somewhat the pace of our securities purchases, perhaps as early as this summer” (Bloomberg News).
Though the Fed has stated that it will continue its accommodative monetary policies until the unemployment rate in the United States has been reduced from its current rate of 7.5% to a target of 6.5%, it appears that the pace of this accommodation may change in the near term. While the consensus among market participants is for this gradual reduction in quantitative easing to begin sometime this year, no one is sure of the scale or the exact timing. As the Central Bank has played such an integral role in helping to engineer the current rally in equities, it will be imperative to closely monitor the deftness with which they handle the extrication of their involvement.