QE Unwind Not Happening

The Fed's balance sheet needs to be studied extensively because of the unique policies the Fed has put in place in the past few years. The difference between what's likely to happen and what's expected to happen is getting larger as we approach Trump's presidency. It's going to be interesting to see when this difference plays itself out. The economic data worsening, the quarter point rate hike in December, or one of Trump's initial policies may be the catalyst for the market to realize the situation at hand.

The differentiation I'm referring to is the market's assumption the Fed can raise interest rates and sell the $4.5 trillion in assets on its balance sheet as the economy improves under Trump even as we are due for a recession. I view the exact opposite policy as likely as I think the Fed will have to buy bonds to pay for any deficit spending. Trumpā€˜s plans call for issuing debt with longer maturity dates which have higher interest rates. This excess spending will call on the Fed to foot the bill.

There is also a cognitive dissonance in the market. The market believes the Fed will coddle it by easing back at any sign of turmoil. Selling the assets and raising rates is what will cause the volatility in the first place, so how can the Fed protect the market from its own policies? If you logically extend the expectations of the market, there is the implicit guarantee the Fed will buy corporate bonds and stocks in the next recession. It's as if the market only wants to recognize the possibility of there being another recession if it comes with stock buying. Only bullish scenarios are assumed to be possible.

You may have seen the chart of the Fed's balance sheet before. It's been relatively steady for the past few quarters. I was reading an article on WolfStreet.com which zoomed in on the recent trends in the balance sheet. As you can see in the chart below, the balance sheet has shrunken 1.55% or $70 billion since the peak. Within the movement, backed security holdings fell $10 billion and federal agency debt securities fell $20 billion. indexed notes and bonds increased 8% to $106.7 billion. This makes sense because inflation has been creeping higher. The movement actually started before Trump even was elected, but has accelerated since then.

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