Market Anticipates Quantitative Tightening

The market continues to rise; people are excited about the Fed meeting that start tomorrow and concludes on Wednesday.  Nobody expects a rate hike and there's not going to be a rate hike, but what everybody is looking forward to is the Fed outlining its strategy for quantitative tightening.

Shrinking the Balance Sheet

The Fed hasn't actually used those words yet; I use that term because what they are going to do is they are going to shrink their balance sheet.  Right now, it's pretty much as large as it's ever been ever since it has done QE: just over $4.5 trillion.  The idea is that the Fed is going to lay out a timetable or a roadmap for shrinking this balance sheet.

Upward Pressure on Interest Rates

I don't know why the markets are so excited about the prospect of a plan to shrink the Fed's balance sheet; if the Fed actually shrunk the balance sheet the markets would not like it. This would put dramatic upward pressure on interest rates, which is not good for stocks.

GDP Estimates Down

Also, GDP forecasts are coming down, we had big reductions late last week. Much of the reductions came from bad economic data we received before the hurricanes. Now, in the aftermath of hurricanes, that bad economic data is going to get even worse.  They are already tallying up the damage from Irma and Harvey and it is enormous.

Real Estate Under Water

Speaking about real estate, there are many people who did not have flood insurance.  The question is: What are they going to do with their houses? Are they going to borrow more money with low interest rate government loans and be deeper under water? Or are they going to walk away from their homes and just give these underwater housed back to the bank? Also, if Maria hits Puerto Rico and does a lot of damage, the U.S. government will have to pay for some of that.

Government Spending Increase

With all this bad news about the economy, why is the Fed going to try to make it worse by shrinking its balance sheet? The budget deficit is already going to explode; all the hurricane relief money needs to be borrowed.  Trump is promising to roll out the Republican tax cut plan by the end of the month and it may be a joint efforts with the Democrats.  They've already said it will increase the deficit.  If the deal is with the Democrats, it will no only mean less tax revenue, it will also mean big increases in government spending.

Money for Hurricane Damage - Money for Everybody!

So not only will we be paying for hurricane damage, there will be new infrastructure spending, new money for the military - who knows if we get money for the wall? Maybe it's going to be money for everybody, the Democrats and Republicans coming together to fill everybody's Christmas stocking with goodies for the voters.  How is the Federal Reserve going to add to the pressure?

Who Will Buy Government Bonds?

Remember: if the Treasury is going to borrow more money, that's more bonds being offered for sale. If the Federal Reserve is not only not a buyer for those bonds (which it normally would do), if it is shrinking its balance sheets it cannot buy any of them. So now the Federal government, the Treasury, is going to have to go into the private market to sell well over a trillion dollars worth of treasuries to finance next year's budget deficit without any help from the Fed.

Repay Fed Plus Finance New Borrowing

But not only is the Fed not going to help, the Treasury will be in competition with the Fed.  They will both be trying to unload treasuries at the same time. In other words, if the Federal Reserve refuses to roll over the maturing bonds, or refuses to reinvest the interest payments they earn, then the Treasury will have to sell those bonds, too. They have to sell enough bonds to repay the Fed in addition to finance all the new borrowing.