How Is the Fed Going to Unwind Its Massive Balance Sheet?

The Federal Reserve faces a dilemma: What to do with all the debt securities it amassed during its stimulus program, known as quantitative easing, or QE. Does the central bank sell off its holdings or hold them until they mature?

The amount involved is staggering. The Fed now has $4.2 trillion on its balance sheet, which is made up of $2.5 trillion of Treasuries and another $1.7 trillion of mortgage-backed securities. Before the financial crisis, the Fed had about $1 trillion in Treasuries.

Over all of the several QE programs, it injected about $3.2 trillion into the economic system. The Fed hoped that this cash infusion would spur the economy. The European Central Bank has had a much less ambitious asset-buying plan, but is contemplating an expansion next year. The 18-nation eurozone economic recovery is anemic and the region may fall back into recession. Without QE, we too might have a very sluggish economy teetering on the edge of recession.

For the Fed, the prospect of unwinding its massive QE assets carries many risks. Consider its inventory of mortgage-backed securities. It receives the interest each month, and as homeowners repay the mortgages, the Fed collects the outstanding principal on the loans.

The Fed directors must decide whether to reinvest the principal and interest proceeds. If they reinvest by buying new mortgage-backeds, that will likely help hold down mortgage interest rates, but may spark inflation.

On the other hand, if they decide to keep the money – which at the end of each year would go back into the U.S. Treasury, thus taking it out of the system – interest rates could move up. If the Fed withdraws the money too fast, it will likely cause a spike that raises rates rapidly, a negative for the economy.

The Fed faces a similar decision with the Treasuries it owns as the notes make interest payments quarterly and principal payments are made at maturity. So, they still have a lot of work to do in unwinding QE and it will likely take years before the work is done.

Mladen Antonov/AFP/Getty Images

Mladen Antonov/AFP/Getty Images

Buying the Fed some time is that the U.S. economy is expanding nicely. The government recently released the updated gross domestic product numbers for the third quarter. The original number was 3.6%, and many thought it would be revised downward. Instead, the third quarter was stronger, coming in at 5.0%. Following on the heels of the second quarter increase of 4.6%, this represented the best two-quarter gain in GDP in 11 years. On top of the GDP number is the employment numbers this year, which peaked in November with 321,000 new non-farm jobs.

The U.S. has waited a long time to see this kind of expected growth coming out of a recession. When the stock market was finishing up its 9.9% tumble of September and early October, many forecasted a complete collapse of the economy and in turn the market.

It takes a long time to turn a battleship, especially when you consider the very rough waters the Great Recession created. It will take another long time for the battleship to turn again in a negative direction. Momentum can be a wonderful thing, or not, depending on its direction.

My firm expects the fourth quarter to be good, but not as good as the last two periods, and this momentum should carry over into 2015. At some point the markets will shake investors again, like they did in early fall. Wise investing is like watching a man walking up a flight of stairs with a yo-yo. Take your eyes off the yo-yo’s up and down motion, and keep them on the man’s progress climbing the stairs.

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V. Raymond Ferrara, CFP, CSA, is president and chief executive of ProVise Management Group LLC in Clearwater, Fla. 

This material represents an assessment of the market and economic environment at a specific point in time. Due to various factors, including changing market conditions, the contents may no longer be reflective of current opinions or positions. It is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Please remember that past performance may not be indicative of future results.

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