The Fed Balance Sheet Unwind Explained

On November 25th, 2008 the Federal Reserve started an unprecedented experiment to back stop the stock market crash.

The former chairman of the Fed, Ben Bernanke announced that the Fed would begin purchasing mortgage backed securities and US treasuries on the open market.

When the Federal Reserve would purchase bonds and treasuries, they would pay for them in cash.  This influx of cash created much needed liquidity at the time.  This provided cash flow to financial institutions and markets, and a lot of confidence in markets.  This is what we call “quantitative easing”.

On October 9th of 2014 the Fed ended it’s quantitative easing program (QE3) and stopped purchasing assets on a monthly basis.

But by this time, they had amassed a $4.4 T book of bonds and treasuries.  This is what is often called the “balance sheet”.

On September 20th, 2017 – Janet Yellen, current Fed chairwoman announced they would officially start to slowly sell their assets.

But who will buy them, and what effect will it have on the market?

The Fed Balance Sheet Unwind – What Does the Fed Own?

Here is a break down of the massive $4.4T balance sheet by security type and the evolution of Quantitative Easing:

• $1.7 Trillion USD in Mortgage Backed Securities
• $2.4 Trillion USD in various maturity Treasury Bonds

The Fed Balance Sheet Unwind – Most Traders Wrongly Think the Fed Hasn’t Been Easing all these Years – But…

Some traders may know that the Federal Reserve stopped buying additional bonds in 2014.

However, most do not know that this did not mean they stopped purchasing bonds.

When bonds matured and fell off the balance sheet, the Federal Reserve would purchase the same dollar amount once again to maintain their holdings.

This open market purchasing had the effect of providing continuing market support and providing additional and regular liquidity.  This liquidity made it’s way through to the stock market, pushing asset prices to record highs.

Mean while, the average American citizen did not benefit one bit. The only inflation, or improvement in the last 9 years has been in the stock market.

The Fed Balance Sheet Unwind – What is the Exit Strategy for these Assets?

But now the Federal Reserve is planning to sell these assets, and the markets is deathly afraid.

It’s time to pull all of the free and cheap money from the economy.

On Wednesday September 20th, 2017, Janet Yellen announced the Fed will:

• Sell $10 BN USD worth of assets starting in October
• Increase to $50 BN USD worth of assets eventually
• Sell assets slowly and gradually to reduce market fears of this coming supply of assets

Here is a snapshot of the planned normalization of the Federal Reserve balance sheet.  The Fed is in light blue.  The chart below is a great contrast between the Fed and global central banks who are also planning to reduce liquidity eventually, but are still easing currently.

This process of selling assets on the open market is called the “balance sheet normalization”.  It’s interesting that this term was selected, because this entire easing process has been a massive and global experiment.

The market has never before witnessed this, and the truth is no one really knows the total outcome.

However, what we do know is that there is a lot of inventory that is about to go on sale.

Even though at first the Fed will only sell small amounts on a monthly basis, the market knows the extent of assets on the book that must be sold off eventually.  This is freaking traders and institutions out more then they will admit.

What happens when a rush of supply suddenly shows up at any market?

Prices go down. Simple.

The Fed Balance Sheet Unwind – How Will Markets React?

When any one person has large quantities of inventory and decides to sell them, they must find buyers.

The question is who the heck will want to own these US bonds and mortgage backed securities?

Saudi Arabia, China and Japan already own large amount of these assets and are slowly selling them off themselves to raise capital for their own issues at home.

Institutions are grotesquely invested in big tech stocks and have little cash flow or interest for owning bonds.

Retail investors are worse off in 2017 then in 2008 and are working multiple part time jobs to make up for their lost jobs years ago.

Who will purchase these assets then?

The real answer is very scary.

The truth is, no one will be aggressively buying them.  That’s why the Fed has only decided to sell $10 BN a month.  It is very interesting to see how this massive unwind will be accepted into the market as quantities increase to $50BN and higher.

Some analysts are predicting a huge drop in bond prices, as much as 20%.  The trouble is that lower bond prices have the consumer crushing impact of higher interest rates, which translates to higher borrowing costs.

Let’s assume suddenly institutions decide for whatever reason they want to buy these bonds. (Fed nudges them behind the scenes).

How will they get the cash?

Sell equities to finance their purchases!

This leads to the following worrying conclusion: the US stock market would have to drop about 20% to generate enough cash flow to absorb the Fed inventory.

The Fed Balance Sheet Unwind – Conclusion

Overall, there is not one person in the world that can tell you what will happen in the next few years.

One thing is for certain, these are unprecedented times and Janet Yellen has got the ball rolling on a historic event.

The balance sheet unwind, or normalization is a very scare prospect to institutional traders and managers.

But it can be just as devastating to the every day citizen.

We are about to move into a period of uncertainty and the unknown, and I think no matter what happens the market will have to drop to adjust and price this uncertainty in.

The bottom line is that you have to start taking control of your investments.  No one cares about your hard earned savings more than YOU.  The easy money is in the last chapter of it’s book.  

Join us and find out how to manage your money yourself and take advantage of this upcoming volatility.

There will be more opportunity to profit as markets drop if you know how to take advantage.

Every professional trader knows it’s very easy to accumulate a massive long position.

But it’s an entirely different thing to find buyers to offload a massive trade.

The Federal Reserve is about to find this out as it starts to unwind it’s balance sheet.

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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.