Loose Financial Conditions force Janet Yellen’s hand

Last week, the US Federal Reserve announced for the first time its plans for unwinding its $4.5 trillion balance sheet that’s been accumulated over the past decade since the financial crisis.

Wall Street has been waiting for such a plan for many years, and now the Fed has revealed its hand, it seems analysts do not know how to react.

Economic Sentiment Janet Yellen Fed Federal Reserve and if you can add also QE quantitative easing interest rates ZIRP rising rates treasuries Ben Bernanke macro Helicopter Money

The Fed has announced that it will begin to unwind its balance sheet by slowing its reinvestment program. At present, the Fed reinvests all of the principle it receives every month from maturing securities. At some point (expected during the second half of 2017) policymakers are going to slow this reinvestment program. When the unwind begins, the Fed is planning to let $6 billion of securities a month mature with any funds over this amount reinvested. From this level, the cap will increase by around $6 billion every three months over the course of the year until it hits $30 billion a month. The Fed said it would ultimately have a balance sheet “appreciably below that seen in recent years but larger than before the financial crisis”, a wide range considering before the crisis the bank had $800 billion in assets, a relatively small sum compared to today’s $4.5 trillion.

Ever since the central bank began its quantitative easing program, there have been concerns about how policymakers will unwind the balance sheet, and whether or not the market will be able to take the additional supply. According to Bloomberg, if the Fed suddenly stopped reinvestment activity without a cap, the balance sheet would shrink by around $280 billion over seven months, and $650 billion in 2018, of this $650 billion total, $224 billion would be mortgage-backed securities. Analysts had previously calculated that the Fed would have to set a role off cap. of $10 billion-$12 billion, increasing every quarter. But it seems policymakers have decided to take a more cautious approach.

Financial Conditions

Loose Financial Conditions force Fed move

According to Bank of America, central banks have spent an estimated $10.8 trillion on financial assets since Lehman Bros, and year-to-date have brought a massive $1.5 trillion inciting the bank’s so-called “Icarus trade” and renewed demand for tech and high yield.

Demand for fixed income securities doesn’t seem to be dissipating just yet with Bank of America reporting that during the second week of June equities and bond funds recorded their second largest ever week of inflows. During the period equity funds attracted $24.6 billion and bonds attracted $9 billion for a total of $33.6 billion, below the largest ever combined inflow of $35.5 billion seen in December 2014. High yielding fixed income products have been by far the largest beneficiaries in recent weeks with inflows of $35 billion during the four weeks to June 15.

Investors are piling into financial assets amid the loose financial conditions, and this is why, Bank of America’s chief investment strategist Michael Hartnett, speculates that the Fed has decided to begin its great unwind.

As shown in the chart below financial conditions are extremely loose compared to history and as a result, the Fed has “announced balance sheet reduction this week to subdue Wall St speculation, not to rein-in Main St boom” as policymakers are looking to “reduce inequality via lower asset prices” and produce “tighter financial conditions”.

Financial Conditions Financial Conditions Loose Financial Conditions