Why you shouldn’t worry about the Fed shrinking its balance sheet; 5 solid reasons

Federal_reserve

By V K Sharma

The Federal Open Market Committee, the policy-making the arm of the US Federal Reserve on Thursday, decided to keep the interest rates unchanged but embarked on the journey of the pruning its USD 4.5 trillion balance sheet.

A journey that has never been undertaken before!

Way back before the global financial crisis hit the US, the Fed’s portfolio was USD 0.94 trillion. Then, as the crisis hit full force in the last three months of 2008 after the Lehman Brothers collapse, the portfolio more than doubled, ending that year at slightly north of USD 2 trillion.

The process continued till about January 2015, by which time the balance sheet had ballooned to USD 4.56 trillion. Today, the balance sheet is just a shade lower at USD 4.52 trillion, a rise of 380 percent from 2008.

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The S&P 500 meanwhile has jumped from 666 in March 2009 to 2508 on Wednesday, a rise of 276 percent. The biggest worry for the markets is that the markets had risen on the back liquidity infusion by the central bank.

Now when the central bank drains liquidity, the markets would tank. The dot plot of the various FOMC members indicates that the committee is expecting a rate hike in December and another three in the calendar year 2018.

Unwinding the balance sheet is significant both because of its sheer size and the impact it could have on markets, as Fed members including Chair Janet Yellen have indicated that the move itself would amount to a rate hike.

I think there are not one but many reasons, why shouldn’t worry about the Fed unwinding.

1. It is a gradual Selling

The Fed would begin selling bonds and securities worth USD 10 billion every month from October. Every quarter this amount will go up by USD 10 billion till it reaches USD 50 billion per month.

By this December 2018, the Fed would have sold just USD 450 billion worth of assets. In the year 2019, the Fed could at the most sell USD 600 billion. All told not more than USD 1.050 trillion by December 2019. What dent could it make?

2. Earnings set to rise

While liquidity drives the markets, earnings also play a good role. Markets could do well because of the expected earnings growth. The S&P earnings are set to rise 20% in CY 2017 as compared to a flat performance in CY 2016. For CY 2018, there is a further 11 % rise in earnings expected.

In the case of the Nifty also, the earnings are likely to rise, notwithstanding the incoming gloomy economic data. No doubt that the earnings growth has been trimmed from Rs 500 per share to Rs 480 per share, it will still be a 14 percent growth.

Compare this to the total earnings growth of just 4.2 percent in the last four years.

3. Fed’s dot plots don’t mean a thing

In June 2015, Fed officials anticipated that interest rates in 2017 would be somewhere between 2.5 percent and 3.75 percent. So much for their vision.

Going back further in in June 2014, the Fed was anticipating that interest rates this year would be between 2 percent and 3 percent, when in fact they haven't risen above 1 percent.

If you look at the last 3 years, you would note that the Fed has consistently anticipated that the next three years will ring in a stronger economy, a higher inflation and therefore the need for higher interest rates. The economy does not really behave the way Fed thinks.

4. Fed’s policies are not cast in iron

The Federal Reserve is open to changing tack midway if it feels that the economy cannot absorb the selling of bonds.

In fact, the timetable what the fed has communicated can be changed if need be. After beginning interest rate hikes in December 2015, it could only hike once in all of 2016.

5. Fed is not the only game in town

While the Fed has stopped buying bonds since January 2015, other players like the ECB and BOJ have continued to provide the liquidity. The two banks have pumped in close to USD 4.8 trillion after the Fed stopped.

We believe the Fed is doing the right thing by lightening its balance sheet when it can. This will enable the Fed to keep its powder dry should any problem arise in the future.

In fact, the market could have suffered a sharper setback had the Fed not initiated the unwinding process at this meeting. That would have raised question marks about the state of the economy.

The image of a stronger and able Fed, willing to unwind the liquidity is better than that of a weak Fed not having the courage to start the unwinding fearful of a cascading effect.

Investors really don’t have to worry about the Fed beginning to lighten its balance sheet. The fact that the Fed is talking about actually doing it, is a statement of confidence that should enthuse the investors rather than discourage them.

We for one consider this as an important fear point that the world was afraid of. And that has been crossed. We see it as a buying opportunity.

Disclaimer: The author is Head - PCG and Capital Market Strategy at HDFC Securities. The views and investment tips expressed by investment experts on moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decision.