With the Federal Reserve not only ending its asset purchases but now also cutting the size of its balance sheet and raising its target federal funds rate, markets are having to deal with the fact that we\u2019re exiting what has essentially been 14 years of extraordinarily loose monetary policy. Can markets still function without this monetary policy backstop?<\/p>\n
Just think that for over a decade Wall Street has been playing with house money, being able to borrow money at just about no cost and expecting a Federal Reserve bailout if things start to look bad. Anyone starting out on Wall Street in the mid-2000s has spent nearly half a career expecting that to be normal.<\/p>\n
Now that markets are expected to return to market discipline and interest rates are supposed to normalize, what effects will that have? Will markets be able to adjust? And how might that impact your financial situation?<\/p>\n
Let\u2019s look at mortgage markets first, which were among the first to react to the Fed\u2019s change in monetary policy. And that\u2019s because they were among the markets to benefit the most from the Fed\u2019s loose monetary policy, just like they were before 2008.<\/p>\n
The Fed\u2019s asset purchase program purchased agency mortgage-backed securities (MBS), and purchased so many that the Fed owned nearly one quarter of the entire mortgage-backed securities market. In other words, the Fed was a market maker, and the reason that interest rates remained so low for so long.<\/p>\n
Mortgage rates spiked in the aftermath of the Fed\u2019s decision to end its asset purchases and start cutting the size of its balance sheet. And we have yet to see how high rates could go as the Fed not only raises the federal funds rate but also sells off its MBS holdings.<\/p>\n
Mortgage rates are currently sitting around 5.6% for a 30-year mortgage, after having previously risen to nearly 6%. That has added significantly to the burden on potential homebuyers, raising the monthly cost of homeownership to levels that many can\u2019t afford.<\/p>\n
Home prices have yet to really reflect that new cost, and it could be a while before housing prices adjust to the new normal. But eventually prices will have to fall, as buyers just won\u2019t be able to afford higher interest rates at today\u2019s inflated housing prices.<\/p>\n
For most Americans, their house is their most valuable asset. And many people treat their houses as an asset, or as a piggy bank. They\u2019ll take out home equity lines of credit in order to fund other purchases, and when they retire they often expect to be able to cash out by selling their home and downsizing.<\/p>\n
To say that the mortgage market and housing market will be upended by the Fed\u2019s change of policy is a little bit of an understatement. Assuming the Fed sticks to its guns, we could see upheaval in the housing market that\u2019s even more severe than 2008.<\/p>\n
Financial markets are also having to deal with the end of easy money. Interest rates are increasing, and with no new money being created by the Fed, markets are now going to have to try to return to normal, a normal that no one has experienced for over a decade.<\/p>\n
Bond markets are going to be roiled, as interest rates rising will decrease bond prices. Companies that thought they would be able to continue rolling over debt at low interest rates are going to find out the hard way that that just isn\u2019t possible, which could put numerous companies in dire financial straits.<\/p>\n
With nearly 20% of American companies reputed to be zombie companies, those who are only able to pay the interest on their debt, these rising interest rates could be fatal. Could you imagine a scenario in which 20% of American companies went out of business because they couldn\u2019t finance their operations?<\/p>\n
That might have seemed far-fetched at one point, but today it\u2019s a very real possibility. And the higher interest rates rise, the worse the problem could get.<\/p>\n
The big wild card, of course, is the Federal Reserve. The last time the Fed tried to raise interest rates and cut its balance sheet, it didn\u2019t get very far before the clamor from Wall Street became too great.<\/p>\n
Returning to normalcy means the pain of an economic slowdown, and the last time that slowdown was imminent, the Fed cut its plans short. So do we really believe that the Fed is going to stick to its guns this time around?<\/p>\n
What markets really need today is a Fed that has a determined plan of action and that doesn\u2019t change its mind every 3-6 months. But markets are already starting to price in a Fed about-face.<\/p>\n
Right now the expectation is for the Fed to continue hiking rates at its July meeting but to potentially pause thereafter as the US economy falls into recession. No one expects the Fed to continue hiking rates after a recession is officially declared.<\/p>\n
But will the Fed continue its balance sheet reduction after a recession begins? Or will it immediately flip back to more quantitative easing to try to soften the recession\u2019s blow?<\/p>\n
Continuing on course means pursuing the same path as Paul Volcker, who made the tough but necessary decision to risk a severe recession in order to tame inflation. Or will Jay Powell go down in history as the next William Miller, Volcker\u2019s hapless predecessor who was fully unfit for the position of Fed Chairman?<\/p>\n
Worsening a recession is going to be politically unpalatable, particularly with an important mid-term election coming up. So the pressure on Powell to stop tightening and start easing could get intense.<\/p>\n
Investors are also going to have to face the return to normal, as markets can no longer rely on cheap money or Federal Reserve bailouts. That means that markets for stocks and bonds could end up looking far different in the coming years than they otherwise would have.<\/p>\n
Already we\u2019re seeing signs of nervousness on Wall Street, with unease about the future of the economy and the likelihood of recession. And many investors have already decided to hedge against the risk of recession by buying gold.<\/p>\n