That was one of the consequences of the monetary policies put into effect in response to the worldwide economic collapse. When the government acted as an artificial buyer of a huge amount of fixed income securities, it forced interest rates down to historic lows. This was intentional as Fed chairman Ben Bernanke and his successor Janet Yellen wanted to force investors to take on more risk in the quest to generate income. In the fixed income space, it caused frenetic activity in the junk-rated debt market and new bond issuance therefore boomed. After a pause in December 2018 with no new issuance, 2019 began with a torrid new amount of junk-rated debt issuance. In the past, elevated high-risk debt issuance has foreshadowed heightened levels of future distress, and that is likely this time around too.
Quantitative easing had never been tried before the financial crisis hit. The US was the first to adapt this strategy in response and as the crisis spread, other nations followed suit. When QE started, total assets on the US Federal Reserve balance sheet stood at ~$850 billion, but through successive rounds of quantitative easing that number grew to ~$4.5 trillion. The idea was to generate so much demand for lower risk fixed income securities that their implied interest rates would drop (since rates move inversely to bond prices) so much that investors would feel more comfortable making higher-risk investments in sectors of the economy that were suffering.
Initially, the focus of QT was on short-term fixed income securities but in subsequent rounds the policy became increasingly aggressive with a focus on longer-maturity securities. The government was buying any and all things it could, including mortgage-backed securities (MBS), to try and repair the damage. Then, it started to bail out specific companies, with the US government picking winners and losers by buying equity in all the major banks as well as companies like GM, Chrysler, and AIG. The government bought Treasuries, it bought MBS, and it put Fannie Mae and Freddie Mac, the quasi-governmental agencies that finance most US mortgages, into conservatorship.
In short, during the crisis the Fed was willing to try every trick in the book to stimulate inflation and demand as well as to create a few new ones. So, what now?
The US economy is in much better shape. We&a;rsquo;ve seen 10+ years of growth, including the longest equity bull market in history. Inflation seems to be in check while unemployment has dropped to a 50-year low of only 3.8%. In normal times, we&a;rsquo;d see the Fed move to raise interest rates, which they&a;rsquo;ve done nine times since 2015, but in January the Fed announced that it will pause on future rate increases for now.
A much bigger question is, when will the Fed truly normalize its balance sheet and what will that mean? One view is that when the size of the balance sheet ballooned, all that quantitative easing caused the prices of all assets to appreciate, and if those policies are now reversed through quantitative tightening, all asset prices will inevitably fall as a result. That&a;rsquo;s a serious risk.
In much the way that QE started small and got out of hand, the same seems true with QT. Janet Yellen and then Jerome Powell tried not to upset the markets by telegraphing their plans well in advance. Since QE had never been tried before, they wanted market participants to broadly know how the balance sheet would be slimmed down. Like watching paint dry, the initial plan was to start with small monthly increments in October 2017 and let securities mature and expire without purchasing replacements. It started small, but by October 2018, it ramped up to $50 billion in MBS and Treasuries that were expiring each month without the Fed repurchasing. This level of QT was much more impactful than small step (0.25%) increases in short-term interest rates.
In fact, QT policy was a major contributor to much of the market volatility that we saw late last year. Now, after extremely volatile market conditions in December, the Fed stopped raising interest rates altogether. Fed officials also indicated last week that, while monthly QT continues, in May 2019 they plan to reduce the cap on monthly Treasury redemption QT from $30 billion/month to $15 billion and then bring it to a complete halt in September. At that point, the Fed&a;rsquo;s balance sheet will still contain over $3.5 trillion in bonds, which is far above normal. In addition, the Fed announced plans to change the mix of Treasuries versus Agency &a;amp; MBS debt it owns by allowing Agency &a;amp; MBS debt to keep declining while reinvesting that cash into Treasuries, subject to a cap of $20 billion/month. At the same time, the Fed will seek to match the duration of the Treasuries it owns with the overall duration of Treasuries outstanding &a;ndash; thus, reducing overall demand for long-dated Treasuries and replacing it with demand for shorter-dated paper. The reason for the change in duration is that doing this will likely change the overall shape (an important leading economic indicator) of the yield curve &a;ndash; with increased demand (lower interest rates) for short-dated paper and lower demand (higher rates) for long-dated paper, economists who rely on a rising yield curve to predict future economic growth might rest easier.
There&a;rsquo;s always a chance that the Fed will change its mind about when to cease tightening or even make another about face and go back to QE. We&a;rsquo;re in uncharted waters here, but the as the tide goes out, many of those boats that have been lifted, are likely to sink back down. Fortunately, US government fiscal policy (the sister to monetary policy) remains extraordinarily expansionary under President Trump. In that realm, tax cuts, capital repatriation incentives, opportunity zones, deregulation, trade initiatives, a business-friendly supreme court, as well as any potential infrastructure spend, all serve to stimulate growth in the US economy. As such, investors would do well to continue avoiding fixed maturity investments (don&a;rsquo;t fight the Fed) while focusing on value-oriented equities which may benefit from event-driven catalysts. These can be found across lots of industries in both the public and private-to-public equity markets.&l;/p&g;
