Will The Fed Turn Cautious On Rates?
Over the past decade Fed actions have been key to the melt up in financial markets. Meanwhile, economists and pundits have made careers out of parsing the Fed. New Fed Chairman Jerome Powell has intimated he will go ahead with gradual rate hikes despite volatility in the financial markets. He has also intimated he will remain data-dependent before hiking rates, and would like for the PCE to reach or exceed 2% growth for a sustainable period.
PCE has not reached 2% growth in over four years. It grew at 1.7% in 2017 and may not reach or exceed 2% anytime soon. This could force the Fed to stand pat on rates for the near future. However, the Fed has intimated it would unwind its $4 trillion balance sheet. The Fed’s balance sheet peaked at about $4.5 trillion in October 2015. It was $4.4 trillion on March 7th and is expected to continue a gradual decline. The balance sheet has declined over $10 billion per month over the past five months. The gradual selling pressure could push up rates on long bonds which drive mortgages and other long-term loans.
Even if the Fed stands pat on the Fed funds rates, it balance sheet unwind could slow the economy due to rising bond yields. This in turn, could hurt stocks. Rising yields could increase the interest expense corporations pay. Amid record low rates several corporations have engaged in debt-fueled acquisitions and share buybacks. Servicing that debt could become more difficult if bond yields spike over time.
Conclusion
If yields on the long bond rise amid the Fed’s balance sheet unwind it would not be good for stocks. Investors should avoid financial markets until the impact of the Fed’s balance sheet unwind is fully understood.
