bond investors

The Fed’s plan to shrink its giant balance sheet dodges the market’s biggest question

(Federal Reserve Chair Janet Yellen arrives to receive her honorary doctorate degree from New York University (NYU) at Yankee Stadium in the Bronx borough of New York May 21, 2014.Carlo Allegri/Reuters)
The Federal Reserve’s detailed plan for reducing its balance sheet likely starting later this year, presented alongside this week’s interest rate hike, was a bit of obfuscation via transparency.

There was a ton of information, but none of it answered the central question on the minds of investors and bond traders: What will be the balance sheet’s ultimate size?

That, after all, is what will help markets assess just how far the central bank will go to tighten monetary policy as the economic expansion stretches into its ninth year.

The Fed more than quintupled the size of its asset portfolio as it bought Treasury and mortgage bonds to keep long-term interest rates down in response to the Great Recession. As they move to unwind some of those actions, policymakers have thus far left themselves a wide margin for how big the balance sheet will ultimately be.

In introductory remarks made during her press conference on June 14, Yellen stated:

“I can’t tell you what the longer-run normal level of reserve balances will be because that will depend on the Committee’s eventual decisions about how to implement monetary policy most efficiently and effectively in the longer run, as well as a number of as-yet unknown elements, including the banking system’s future demand for reserves and various factors that may affect the daily supply of reserves. What I can tell you is that we anticipate reducing reserve balances and our overall balance sheet to levels appreciably below those seen in recent years but larger than before the financial crisis." 

(Andy Kiersz/Business Insider)
A couple of regional Fed officials who have spoken on the matter have hinted an end-goal somewhere between $2 trillion and $3 trillion.

What is clear is that the central bank has never been quite as comfortable with using its balance sheet as a tool to ease monetary policy as it is with regular old interest rates. The policy-setting Federal Open Market Committee would clearly like to return to a world where interest rates are the primary if not the singular tool of monetary policy.

"Balance sheet policy will run in the background, largely on autopilot, subordinated to the funds rate, which will remain the active lever of policy,” Josh Feinman, chief global economist at Deutsche Asset Management, wrote in a research note to clients. Still, he said, “the effects of balance sheet runoff on financial conditions will be something the FOMC takes into account when setting the funds rate, and if the economy were to veer widely off course, the FOMC would consider adjusting balance sheet policy as well.”

NOW WATCH: We drove a brand-new Tesla Model X from San Francisco to New York — here’s what happened



More From Business Insider
What you need to know on Wall Street today

(AP)
Welcome to Finance Insider, Business Insider’s summary of the top stories of the past 24 hours.

Retail bank branches remain stubbornly relevant, despite an onslaught of digital and tech innovations.

But bank tellers’ days in those branches could be numbered.

The largest banks in the US have been investing millions in updating the capabilities and physical appearances of their thousands of ATMs — an invention that turns 50 years old this month.

Morgan Stanley is turning to text messages to keep in touch with wealthy clients.

The tech stock “fairy tale” is heading for a bad ending. Traders haven’t been this nervous about tech stocks in 14 years. Traders are loading up on bets against Apple. But there’s one big difference between now and the 1999 tech bubble.

Bond investor Bill Gross warned on Tuesday that investors should reduce their risk appetite. Bitcoin is looking “heavy,” according to Goldman Sachs. And Elizabeth Warren just threw down on a Wall Street battleground stock.

Trump’s Treasury Secretary said “talking about impeaching the president is the biggest waste of time.” And Janet Yellen will have a harder time than usual justifying Fed policy at this week’s press conference.

Thomson Reuters is partnering with the “Slack for Wall Street.” A $16 billion hedge fund CIO explained what it takes to work at a hedge fund today. There are three things that Citi’s EMEA investment banking chief will always make time for in his job.

An investment banker has been killed in the first fatality for New York City’s popular bike-share program.

Verizon has closed its $4.48 billion acquisition of Yahoo, and Marissa Mayer is stepping down with $23 million. Read her farewell letter to employees. And Apple is borrowing $1 billion to fight climate change.

Sears Canada says it’s running out of cash and revealed there’s “significant doubt” it can stay in business.

States are starting to stand up to “the new Big Tobacco” because Washington won’t. And investors are being told to go scorched earth on the company that makes EpiPen.

Tesla might soon have a “near-monopolistic” hold on the electric vehicle market. Apple has made a potentially disastrous pivot on self-driving cars, according to Business Insider’s Matt DeBord. And the “Tesla of buses” raised $55 million from Al Gore’s investment arm as it eyes an IPO.

Lastly, here are 28 photos of ripped Wall Streeters testing their physical limits at the most intense competition out there.

NOW WATCH: THE BOTTOM LINE: A deep dive into Tesla’s stock price and Amazon 20 years after its IPO



More From Business Insider
Why the Lousy Jobs Report Boosted Wall Street

The stock market surged yesterday after the lousy jobs report. The Dow soared 160 points Friday, while the S&P 500, and Nasdaq also rose.

How can bad news on Main Street (only 113,000 jobs were created in January, on top of a meager 74,000 in December) cause good news on Wall Street?

Because investors assume:

(1) The Fed will now continue to keep interest rates low. Yes, it has announced its intention of tapering off its so-called “quantitative easing” by buying fewer long-term bonds in the months ahead. But it will likely slow down the tapering. Instead of going down to $55 billion a month of bond-buying by April, it will stay at around $60 billion to $70 billion.

(2) The slowdown in the Fed’s tapering will continue to make buying shares of stock a better deal than buying bonds – thereby pushing investors toward the stock market.

(3) Continued low interest rates will also continue to make it profitable for big investors (including corporations) to borrow money to buy back their own shares of stock, thereby pushing up their values. Apple and other companies that used to spend their spare cash and whatever they could borrow on new inventions are now focusing on short-term stock performance.

(4) With the job situation so poor, most workers will be so desperate to keep their jobs, or land one, that they will work for even less. This will keep profits high, make balance sheets look good, fuel higher stock prices.

But what’s bad for Main Street and good for Wall Street in the short term is bad for both in the long term. The American economy is at a crawl. Median household incomes are dropping. The American middle class doesn’t have the purchasing power to keep the economy going. And as companies focus ever more on short-term share prices at the expense of long-term growth, we’re in for years of sluggish performance.

When, if ever, will Wall Street learn?

This Is Janet Yellen’s Biggest Challenge

The Fed is trying to put back with the right hand what it’s taking away with the left. But it might need to use both together if it’s going to speed up the recovery.

Ever since Lehmangeddon, the Fed has been stuck in a brave, old monetary world where even zero interest rates aren’t enough to jumpstart the economy. It’s a world that, outside of Japan, we haven’t seen since the 1930s. And one that the Fed has tried to find a way out of in fits and starts. By late 2012, it had settled on a two-pronged strategy to do so: purchases and promises. The Fed purchased $85 billion of long-term bonds a month with newly-printed money, and promised to keep rates at zero at least until unemployment fell below 6.5 percent or inflation rose above 2.5 percent.

But now these programs are winding down, and we still haven’t gotten the catch-up growth that’s always a day (or 6-12 months) away. The Fed started this return to normalcy last May when Ben Bernanke said that it would soon start reducing—or, in financial lingo, “tapering"—its bond-buying. Investors didn’t like this surprise, but the Fed didn’t like the one it got either. Even though its forward guidance hadn’t changed at all, the taper talk made markets expect the Fed to start raising rates much sooner than before. In other words, markets didn’t distinguish between the Fed’s purchases and promises. That’s because the purchases are what made the promises credible, the Fed putting its money where its mouth was.

So how much are the Fed’s promises worth today? Well, more than you might think, though there are still a few difficulties.

Read more. [Image: Reuters]