On September 20th, 2017 Janet Yellen announced that the Federal Reserve’s 4 trillion-dollar balance sheet would start shrinking in October 2017. This signals the beginning of the end of the Fed’s Quantitative Easing program (QE), which was started on November 25, 2008. The Fed initiated QE (buying bonds) to help save the economy during the last recession. Near the end of 2014, the Fed ended additional QE, but maintained the size of its balance sheet by reinvesting all bond maturities and income. Starting in October 2017, the Fed will let some of the bonds they own mature, thus shrinking the size of their balance sheet, and reducing QE.
Quantitative Easing lowered interest rates, and boosted the price of almost all financial assets. Not surprisingly, there has been a high correlation between the size of the Fed’s balance sheet (QE), and the S&P 500.
I believe that over the long term, the winding down of QE will lead to:
- Higher interest rates (My fingers are crossed!)
- A headwind for US stocks, real estate, and other risk assets
However, it is important to note the following:
- Interest rates are unlikely to rocket higher in the near term
- I am not predicting an imminent stock market decline; the tapering of QE simply makes new all-time high prices less likely
- As of now, the European and Japanese central banks are continuing with additional QE, but it is believed that their QE programs may soon be put on hold
If history proves that October 1st, 2017 was not important, my guess is that it will be for one of the following reasons:
- The Fed reverses course, and adds to QE rather than decreasing it
- The European and Japanese central banks add to their QE programs offsetting the Fed’s decrease
Just as history shows that the beginning of QE on November 25, 2008 was important (the S&P 500 bottomed on March 9th, 2009) I believe history will eventually show that October 1st, 2017 was an important date. If I am wrong, US stocks may surpass the record extreme valuations set in the year 2000 despite the simultaneous headwinds of decreasing QE, and expensive valuations.
I purposely used the word ‘headwind’ above since this is not the time to make drastic moves; it’s a perfect time to wait and see what happens next. There should be plenty of time to react to what happens, rather than predict what will happen.