The Federal Reserve has a trick up its sleeve when it comes to interest-rate hikes.
And importantly, it’s playing out right now…
It’s called the “balance sheet runoff.”
You see, during the COVID-19 pandemic, the Fed started buying bonds to keep interest rates low. That process is known as “quantitative easing” – or “QE,” for short.
The Fed’s balance sheet ultimately ballooned to more than $8 trillion.
But now, it’s starting a redemption process to get those bonds off its balance sheet. It’s letting them mature. And that means bond prices are falling.
It’s Economics 101. When fewer buyers are in a market… prices fall.
And remember, prices and rates have an inverse relationship. So when bond prices fall, rates go up.
That means the Fed letting its balance sheet run off is essentially a backdoor rate hike.
But don’t take my word for it…
The man who’s pulling the levers at the Federal Reserve said so himself back in March. At a press conference, Fed Chair Jerome Powell said…
There’s also the shrinkage of the balance sheet. People do the math different ways, but that might be the equivalent of another rate increase.
Today, I want to discuss how this all works. And importantly, we’ll cover what it means for investors…
Let’s start with a chart of the Fed’s balance sheet over the past two decades…
You can draw two quick conclusions from this chart…
First, the 2020 time frame was unprecedented. The Fed bought a lot of bonds in response to the COVID-19 pandemic. And as you can see, the line jumped almost straight up from about $4 trillion to around $7 trillion.
Second, notice that the Fed’s balance-sheet assets are now rolling over. You can clearly see the rounded top at the end of the chart.
As I said earlier, that shows the Fed is letting its balance sheet run off this year.
The Fed’s balance sheet peaked at about $8.97 trillion on April 13. It’s currently at around $8.83 trillion.
Now, I know what you might be thinking…
That’s only a 1.6% decline. It seems like a drop in the bucket.
But the thing is… bond prices have fallen much more than 1.6%.
To see what I mean, let’s look at the iShares 20+ Year Treasury Bond Fund (TLT). As its name implies, this exchange-traded fund holds a basket of U.S. Treasury bonds with maturities longer than 20 years.
TLT started the year at around $148 per share. It’s trading at around $108 per share today – a staggering 27% decline in roughly nine months. Take a look…
At the end of last year, I warned that something like this could happen. After the Fed announced its plan to stop buying bonds, I said in the December 23 PowerFeed…
Folks, the Fed is making it clear… Bondholders can pound sand today.
So for now, your best bet is to step aside from bonds while the Fed does its dirty work to tackle inflation.
Now, you might be wondering… why are bonds selling off so much?
Bond-market investors are some of the smartest folks on Wall Street. They’re “frontrunning” the Fed and selling their bonds ahead of the central bank’s redemptions.
And why does this matter to us as investors?
To put it simply, as the Fed’s balance-sheet runoff accelerates, rates will go higher. When rates go higher, business slows down. And of course, slowing business is bad for stocks.
But the worst news is this… We’re closer to the beginning of this cycle than the end.
The Fed still has a lot of rate hiking to do to get inflation under control. And it can use two powerful levers to do that…
As I discussed on Wednesday, it can simply raise the “federal funds rate.” And secondly, it could pull the lever we looked at today – its balance-sheet runoff.
It’s a little convoluted. But the reality is that the Fed is using a backdoor way to raise rates by ending its purchase of bonds and letting its portfolio shrink.
And as long as that’s in play… investors like us will need to endure a very tough market.
Good investing,
Pete Carmasino
