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Ramifications of the Fed’s Portfolio Exit

While raising interest rates seems to be on everyone’s minds these days, there’s a far more important policy tool that could be on the table – asset runoff. One of the key impacts of QE is the portfolio rebalancing effect. This occurs as a result of the Fed’s removal of bonds from the private sector. This change in the composition of the private sector’s financial assets forces investors to rebalance their portfolios. This likely increases demand for bonds and other safe assets. This puts a floor under assets like T-bonds because, all else being equal, the reduction in supply should boost the price of these assets and potentially other assets. There is also a strong behavioral impact resulting from QE and the Fed’s implicit support of the markets.

The operational realities of QE are important for portfolio management given that misunderstanding the program and its effects could leave you positioned incorrectly. For instance, those investors who didn’t understand how QE works were likely to argue that the “money printing” could lead to high inflation which would lead one to invest in real assets like commodities and gold. It could also lead one to believe that it’s wise to short government bonds based on the assumption that QE could cause inflation which could drive up interest rates. Of course, this all turned out to be completely wrong as I noted regularly over the last few years.  If you didn’t understand QE over the last 6 years you were at a significant disadvantage.

That said, this comment from Goldman Sachs piqued my interest:

Sometime after the first hike the Fed will allow its balance sheet to begin shrinking, resulting in a gradual increase in the term premium. … Our forecast for the start of portfolio runoff is 2016 Q1, with risk skewed toward a later date, and we think that the initial step will probably be a switch to a policy of partial reinvestment. Although the Fed has stated that asset sales are not part of its normalization plan at this time, it is possible to imagine scenarios which could push the Fed in this direction.

The timing of the portfolio runoff, should it occur, is likely to be extremely important for investors. When the Fed’s balance sheet stops expanding and potentially shrinks, it will mean an increased supply of bonds on the market. And that will generate a portfolio rebalancing in reverse. If Goldman is right and this event begins in Q1 2016 then investors would be wise to prepare in advance because the markets won’t wait until after this all begins to price in the effects.