As the Federal Reserve continues to normalize monetary policy from the extraordinary measures of 0% interest rates and quantitative easing through asset purchases, most of the focus has been on rate increases.

Jim Palmer, Chief Investment Officer

As the Federal Reserve (Fed) continues to normalize monetary policy from the extraordinary measures of 0% interest rates and quantitative easing through asset purchases, most of the focus has been on rate increases. The Fed has raised benchmark rates 25 basis points eight times since December 2015 and is expected to lift rates again at the December 19^th meeting. Further, the Fed's September Dot Plot median forecast called for three additional rate hikes in 2019. All of which has pushed rates higher across the yield curve and tightened financial conditions. Hawkish Fed rate policies and the promise for more have also been partially blamed for the increase in risk asset volatility in recent weeks.

But there is a less public form of monetary tightening occurring that is impacting bank deposit funding and risk asset valuations - the unwind of quantitative easing, or quantitative tightening for lack of a better term. Since the Fed began gradually reducing the re-investment of principal payments in the System Open Market Account (SOMA) in the fourth quarter of 2017, its balance sheet has shrunk along with some key components:

While Fed rate hikes are widely publicized and are readily observable in money market rates, the effects of quantitative tightening are less obvious and work their way through the financial system by impacting capital flows and demand for both risk-free and risk assets. Some of these impacts may include:

1. Pushing yield curve levels higher than they otherwise would be by eliminating a large buyer of U.S. Treasuries during a period of rising federal deficits and issuance

2. Negatively impacting risk asset and stock market valuations through diminished purchases of market assets

3. Removing reserves from the banking system at a point when there is strong demand from banks for regulatory-friendly liquid assets

4. Increasing competition among banks for deposit funding

Tighter financial conditions are an expected and natural outcome of the Fed's balance sheet unwind. Given recent financial market volatility, investors would be wise to pay close attention to the Fed's balance sheet decisions as well as its more visible interest rate policies.

Sources

Bloomberg

Federal Reserve Statistical Release, Factors Affecting Reserve Balances, September 28, 2017

Federal Reserve Statistical Release, Factors Affecting Reserve Balances, November 15, 2018

FOMC Economic Projections, September 26, 2018