The Fed just finished their latest meeting without changing the headline rate. This was not much of a surprise as recent inflation data have come in higher than hoped. However, there was something of a silver lining for stocks as the Fed said they would reduce the speed at which they shrink their balance sheet starting in June. They were reducing it by about $60 billion dollars of Treasury bonds and $35 billion of mortgage-backed securities each month. Starting in June, they will reduce the amount of Treasury bonds that they allow to roll off to $25 billion. That is a significant change from a total of $95 billion to a total of $60 billion each month.
If you think of the headline interest rate as a sledgehammer and the change in the size of the balance sheet as a regular hammer, then you can see why this move is interesting. When they decrease the size of their balance sheet, they are essentially flooding the market with bonds. Simple supply and demand will tell you that if there is an oversupply of something its price will tend to go down. Now that they plan to flood the market with fewer bonds, the price of those bonds should go up somewhat. When the price of bonds go up, their effective interest rate declines. So this is the first significant step towards lowering interest rates. While it is not a huge step, it does reinforce the likelihood that the next step will be to lower rates and not raise them, as well as signal that they are getting closer to using their more powerful tool of the fed funds rate.
The stock market has not been waiting patiently for the Fed to lower rates, so this move should ease some minds that the Fed won’t start to ease up on its monetary policy until inflation hits 2%. Right now it is at just under 3% and many people have been focusing solely on that number. 3% isn’t 2%, so therefore the Fed won’t change anything. This isn’t likely to be the case if you’re trying to slow down something as large as the US economy, you don’t just slam on the brakes and hold them until you’re at the exact speed you want. You start to ease off the brakes as you get closer to your target. I believe this is that first step in reducing the pressure on the brakes and hopefully more will follow.
From a portfolio perspective, this doesn’t really change anything. This was in line with our expectations as we expect rates to go down in the next year or so. This is just an indication that that process has begun. If this sparks a continued rally to where stocks become more expensive on a relative basis, then we will reduce our stock exposure if the situation warrants it. Hopefully that is exactly what happens, but again, this is just a small move and more of a footnote than a headline. The market really wants the Fed Funds rate to go down. While we believe it will, it’s just a matter of when it actually happens.
As always, if you have any questions or concerns about your specific situation don’t hesitate to reach out to us.
Enjoy the last of the cooler weather!
