"Like Detoxing From An Addiction": Update On The Fed’s QE Unwinding

Submitted by Convoy Investments

After the global market crash in 2008, the Fed needed to lower interest rates in order to stimulate the economy. However, interest rates were already close to 0% so the Fed resorted to a different form of stimulation - quantitative easing. They directly bought $trillions of bonds in order to directly lower interest rates and increase money supply.

The Fed’s QE over the last decade resuscitated the economy and helped the financial markets go on the longest bull market run in history. However, the Fed now needed to unload the massive bond portfolio on their books and in process mop up the excess money in the financial system. They began the effort to overcome this hangover a few years ago. I believe we are about a third of the way through that process and are now entering the period of the most intense pace of unwinding. The rate of unwinding should start slowing down over the next few years before we finally normalize.

Below I show the portfolio of bonds that the Fed held during the peak of QE at the end of 2014. They held roughly $2.5 trillion with the vast majority in two lumps, about $2 trillion around 5 years in maturity and another $0.5 trillion around 25 years in maturity. This is because starting in 2009, the Fed began to purchase large amounts of 10 year and 30 year bonds and the portfolio aged to this profile 5 years later in 2014.

By the end of 2014, the Fed largely stopped buying new bonds and began to hold this portfolio to maturity. Below I show the same breakdown of bond holdings by maturity year over year in the 4 years since then. As you can see, very few bonds were bought or sold; the Fed has simply let the portfolio age.

In 2014, 5 year maturity was the peak of the $2 trillion lump of bonds. So 5 years later, about right now, we are getting close to the peak rate of bond maturing out of the Fed’s portfolio. Below I show amount of near-term bonds that are maturing in the Fed’s portfolio as of each of the last 5 years. As you can see, 2017 and 2018 are close to the maximum pace of bonds maturing. I believe after the next year, the rate of QE unwinding will begin to slow down and a few years after that, we should see our monetary system largely normalize.

This is reflected in the increasing rate at which excess reserves in our banking system is being mopped up. We are now about 35% off the peak in 2014.

Based on the maturity schedule of the Fed’s current bond portfolio, this is what the reserve balances of our banking system should roughly look like over the next few years all else held equal. I believe we’ll finally see a normalization of our monetary system in a few years.

Decreasing money supply on this scale will continue to be a headwind for assets on average. While US stocks remain an exception, most assets across the world are struggling. Like detoxing from an addiction, this is a period of unpleasant but necessary adjustment.