For investors, following the US Federal Reserve’s policy changes gives us a heads up on possible market movements. Since 2009, the Fed has embarked on an unprecedented policy of quantitative easing with the latest round of buying $85 billion per month of treasuries and mortgage backed securities. The net effect of these policies has been to swell the Fed’s balance sheet to a massive $4.2 trillion. Now the Fed is in the process of unwinding some of this activity. In December 2013 the Fed started “tapering” or reducing these asset purchases. To get a sense of what the Fed is up to we look at the minutes of their recent meetings. These are made public for the previous month. The latest issue was for June 17-18.
There was “general agreement” that the Fed would end its purchase program of treasuries and mortgage backed securities by this October. Now the Fed is looking for other ways to further reduce its balance sheet.
The Fed may have gone a bit too far with this latest round. We find that banks now have “excess reserves” parked at the Fed to the tune of $2.6 trillion. When the Fed purchases securities it credit’s the bank’s balance sheet. Banks have used a large chunk of this money to speculate in the markets. The “excess” is at the Fed drawing interest. This is free money for the banks. The Fed has the option of ending payment of interest on these reserves. That would encourage banks to do more lending. Why the Fed hasn’t done this earlier is a mystery.
The Fed has been drawing interest on its bond purchases and reinvesting the proceeds back into more purchases. It could end this practice but there is some disagreement concerning the right time to do this.
Another tool for tapping down its balance sheet is the use of Reverse Repos. The New York branch has been testing this move since last September. In a reverse repo the Fed borrows funds from the banks overnight. This has the effect of draining money from the system.
The Fed is concerned with the low volatility in the markets. That makes sense since the banks that have been the biggest players in the market now have less money with which to speculate. In addition the general public, by and large, has not returned to the market. Market movement over the past five years has been driven by the banks and large institutional investors. Since they have been the biggest buyers, they could also be the biggest sellers in the event of a downturn.
Some of the low volatility can be attributed to short sellers who are trying to test the market’s upside potential. They dip their feet lightly on the short side and cover quickly if the market turns upward. The short covering causes a new high. This is normal in a bull market.
Other investors are on the sidelines, holding off purchases due to uncertainty in world events and the effect of the Fed’s policy changes.