And now it begins - the "QT" era, that is. After spending nine years doing everything it could dream up to keep the U.S. economy from entering a disinflationary spiral, the Fed will officially begin to "unwind" its balance sheet next month.

In an attempt to return both the central bank's monetary policy and bond holdings back to more normalized levels, Janet Yellen announced yesterday that (a) the current view of the economy and, in turn, the plan for "policy normalization" (aka rate hikes) remains the same and (b) the FOMC will stop reinvesting the interest it receives from its portfolio holdings in October. This means that $6 billion in Treasury Bonds and $4 billion of MBS (mortgage-backed securities) will mature each month. The plan is to then increase that amount by $10 billion a quarter to a maximum of $50 billion a month by October of next year.

The first takeaway here is that the Fed FINALLY feels like it can step away from the life support it has been providing to the economy for nearly a decade. According to Ms. Yellen, "The basic message here is U.S. economic performance has been good." The Fed Chairwoman added at Wednesday's press conference, "The American people should feel the steps we have taken to normalize monetary policy... are well justified given the very substantial progress we've seen in the economy."

The plan is to slowly reduce the Fed's more than $4 Trillion portfolio back to a more reasonable size over the next few years. Instead of continually pumping new cash into the financial system, the Fed wants to get back to "normal" and let markets work on their own. Of course, what this "normalized" level looks like is yet to be determined. And as such, the guessing game for investors about what the Fed plans to do next in the coming quarters is likely to continue unabated.

Getting back to the idea of "QT" or "quantitative tightening" (where the Fed effectively sells bonds on the open market) the key here is that at some point, the Fed will become a net seller of bonds each month. And the bears tell us that this will undoubtedly lead to higher rates, which will slow the economy, hurt profits, yada, yada.

But Before You Panic...

Yes, rates are expected to rise a bit during this process in the coming quarters/years. However, before you run out and start buying those inverse rate ETFs that benefit from rising rates, there are a couple things to understand about the situation.

First and foremost, there are other central banks around the world still employing QE schemes (buying bonds on the open market) every month. For example, the QE programs at ECB and the BOJ are ongoing. Therefore, the demand for U.S. bonds isn't likely to change dramatically in the near term.

Remember, the U.S. Fed hasn't been buying bonds for some time now. And from my seat, it was the lack of supply around the globe that led to all the negative interest rates around the world last year. In essence, it was demand outstripping supply (due to the amount of QE happening around the globe) that caused rates to go negative.

So, with demand for bonds now beginning to fall, we can probably expect rates to "normalize" over time - especially in places like Europe, where rates were arguably artificially low due to all the QE.

In addition, we need to recognize that U.S. banks will likely need to step up their buying of bonds on the open market. You see, when the Fed was buying bonds from banks (via the QE program), it paid for the bonds by crediting the reserves banks held at the Fed with newly created money. This allowed the banking industry's excess reserves to increase - making the banks healthier in the process.

As the Fed's bonds start to mature and are not replaced, the WSJ tells us that the banks' excess reserves will start to fall. And since the new banking regulations require banks to hold "high quality liquid assets" to cover short-term outflows during times of crisis, the banks will need to replace the Fed's bonds when they mature.

So, what are the banks likely to buy in order to keep those excess reserves at healthy levels? Oh that's right, U.S. treasury bonds and/or high quality MBS. Which, by the way, is exactly what the Fed will be selling.

In my opinion, the bottom line here is that the great bond bear that so many have been expecting for quite some time now may continue to be delayed. Sure, rates may rise a bit. But inflation remains contained - something Yellen referred to as "a mystery" yesterday. The economy isn't running hot. And the demand for bonds is likely to remain robust. Therefore, I can argue that the catastrophe for bond investors our furry friends are looking for may not be in the cards any time soon.

But, this remains an area to watch closely as the great QE Era morphs into the QT Era.

Thought For The Day:

Don't cry because it's over. Smile because it happened. -Dr. Seuss

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The State of the Tax Reform

2. The State of the Economic/Earnings Growth (Fast enough to justify valuations?)

3. The State of Geopolitics

4. The State of Fed Policy

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.

Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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