Rev's Forum: Bears Salivate at Fed's Intent to 'Normalize' Its Balance Sheet

 | Jun 15, 2017 | 7:46 AM EDT
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"Don't fight the Fed, exploit it."

--Ted Allrich 

Ever since 2008-09, when the Fed rode to the rescue of the economy with bags of cheap capital, the bears have predicted that the Fed eventually would be the catalyst for the next deep correction. The bull market has lasted far longer than expected and new negative arguments have popped up along the way, but at the core of the pessimistic view were the central banks that were sitting on trillions of dollars of assets that they bought to keep the world economy humming.

Central bankers have assured markets that they were not going to reduce their balance sheets until the economy was strong enough to handle the supply. The market hasn't had any great concern over the issue and has remained optimistic that economic growth was improving and would make the unwind possible.

Yesterday the Federal Open Market Committee (FOMC) moved ahead with its agenda. It raised interest rates a quarter point as anticipated and signaled that another rate hike was coming this year. Janet Yellen was optimistic about the economy and was unconcerned about some recent softness that had occurred.

Most importantly, the Fed signaled that it is going to start to "normalize" its balance sheet. It intends to do this by not replacing bonds it holds as they mature. This means there will be a greater supply of debt for other buyers to buy and that will reduce liquidity to some degree. The thinking is that it won't be a significant headwind to the economy because there will be enough growth to absorb the supply.

The market is expressing some doubts about that thinking this morning. The Fed for eight years has done nothing to contract liquidity, other than a few minor rate hikes. While unwinding its balance sheet will be done very slowly, there is a major psychological issue for a market that has done gloriously well on the old saying about not fighting the Fed. If not fighting the Fed worked so well when the Fed was dovish, shouldn't it work equally well when it is hawkish?

That is the issue facing the market now and we'll see if it matters. The market has done a nice job of shaking off any and all central bank concerns for a long time. The bulls say to not worry about the Fed because the economy can handle higher rates and the 'normalization' of the balance sheet. We are now going to find out how much the market really believes this.

It typically has been a mistake to be too bearish too fast on this sort of macro development. Calling turning points on developments such as has killed the bears for years, so it is important to not be too negative too fast. We need to watch to see if this theme about the Fed balance sheet gains further traction. If it does, then other negatives such as valuations, the lack of progress on the Trump fiscal agenda and seasonality will come into play as well.

We are set for the sort of negative open that dip buyers have found so attractive so often. We shall see very quickly if the headlines have an impact this time.

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