“The stock market has essentially been expecting this for a while,” said David Kass, a professor of finance at the University of Maryland. “It will be a gradual unwind of the Fed balance sheet and has been incorporated into current prices.”
Kass said that so far, the Federal Reserve has straddled a careful line and fulfilled its twin goals of price stability and maximum employment. Now the central bank wants to begin easing back and let the economy run on its own.
But nothing is certain. Just about everything Americans buy, sell and do depends on the cost of money. And the Federal Reserve’s actions on interest rates go a long way toward how much we pay to borrow, whether it’s for a mortgage, a car or next month’s credit card bill.
Investors are watching the Fed closely because its experiment in keeping interest rates super-low for so long has steered the nation’s economy into uncharted territory.
“When you print $4.5 trillion, it’s like spraying a ton of lighter fluid on the barbecue,” said Chris Zaccarelli, chief investment officer at Cornerstone Financial Partners. “It didn’t explode.
“Why?” he said. “We don’t know. You have all this money in circulation, and now you want to take some of that away. Who knows when and if this is going to create a problem.”
Zaccarelli and others expect the Fed’s pace to “normalizing” interest rates to be so glacial that it probably will have little, if any, impact.
“People are comfortable for now,” Zaccarelli said. “The amount being withdrawn is tiny compared to the total amount of $4.5 trillion. Their plans have been very well communicated that they are going to do very little, and do it very slowly.”
But there are signs of disquiet in the markets. Yields on long-term U.S. Treasuries have risen steadily in recent days, a sign of investor concerns over the Fed’s anticipated moves. Yields rise as bond prices fall.
It’s a delicate mission. If the Fed trims its balance sheet too quickly, it could accelerate the rise of interest rates, pushing the price of everything from credit card interest to home mortgages higher.
“In terms of interest rates, the goal is to get back to a level before quantitative easing,” said Kass, referring to the Fed’s strategy of buying government bonds, which helped keep interest rates low. Kass said he expected interest rates to gradually rise to around 3 percent. Rates are between 1 and 1.25 percent currently.
The Fed stepped in to buy government bonds and mortgage-backed securities in 2008 when a crisis in the subprime mortgage market caused the bankruptcy of Lehman Brothers, forced the federal government to take over Fannie Mae and Freddie Mac and threatened a collapse of the global financial system.
The Fed bought $2.5 trillion in U.S. Treasuries and $1.8 trillion in mortgage-backed securities as a way to increase demand and keep yields low, which in turn reduced interest rates to ultra-low levels.
The easy money helped fuel and extraordinary rise of the stock markets since early 2009 — when the Dow Jones industrial average was a mere 7,063 — to Tuesday’s close of 22,370. The Dow, Standard & Poor’s 500-stock index and Nasdaq all closed at record highs Tuesday.
The rising stock market has fattened American portfolios by several trillion dollars. It has helped boost the political fortunes of President Trump, who touted the U.S. stock market Tuesday in a speech before the United Nations, saying “the stock market is at an all-time high, a record.”
The bull market has endured in the face of geopolitical crisis such as North Korea’s nuclear tests and missile launches and dysfunction in Washington’s political circles.
The stock and bond markets’ metrics are so intertwined that if the Fed missteps, some stock sectors could get hurt. Others might flourish.
“If rates were to move higher I’d expect financials to do well , and utilities and real estate to do worse,” Zaccarelli said. “While the materials sector wouldn’t necessarily do better under higher rates directly, if rates are moving higher because of expected future growth and inflation, then that sector should do well.”
If rates rise, ”interest rate sensitive companies that are heavily leveraged, such as slow growth industrial companies, will do poorly,” said Ivan Feinseth, chief investment officer at Tigress Financial Partners. “Banks will benefit from the steeper yield curve, and tech companies that have little debt will see a return on their cash increase as rates rise.”
The Fed since 2014 has been telegraphing its intention to eventually unwind its balance sheet, allowing interest rates to rise. The initial announcement three years ago caused a “taper tantrum” that shook markets. This time appears different.
“They are doing a balancing act,” said Rajeev Sharma, director of fixed income at Foresters Investment Management Company. “When they started doing this back in 2008, we never saw that before. And now, they are going to start letting $6 billion a month in Treasuries run off their balance sheet, and we’ve never seen that before. It sounds like a very well measured plan, but again, we are in very uncharted territory.”