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It’s summertime and financial conditions are easy. So risk markets hardly flinched when the Federal Reserve said Wednesday it will begin to shrink its $4.4 trillion balance sheet “relatively soon.”
That would seem to mean Sept. 19-20, which is when the policy-setting Federal Open Market Committee is slated to meet again. That would be “relatively soon,” in Fedspeak, for the central bank to begin the process of reducing its holdings of Treasury and agency mortgage-backed securities, which it had amassed to pump liquidity into the financial system following the financial crisis.
Now that the 10th anniversary of the beginning of the crisis (which might be marked by the June 2007 failure of Bear Stearns’ hedge funds investing in toxic mortgage derivatives) has passed, the Fed is preparing to begin to withdraw the extraordinary measures taken to cope with the crisis.
To the surprise of no one, the FOMC left its federal funds rate target in a 1%-1.25% range. Market expectations of one more quarter-point hike by December were unchanged by the FOMC’s statement. Fed funds futures imply a 45% probability of such a move by year end, according to Bloomberg data.
As for the Fed’s main mandates, employment and price stability, those criteria were mixed. The FOMC statement noted “job gains have been sold, on average, since the beginning of the year, and the unemployment rate has declined.” At the same time, inflation is likely to remain below the Fed’s 2% target but the panel continues to expect it to stabilize around that level “over the medium term.”
As usual, there was no acknowledgement that the 4.4% jobless rate understates the slack in the labor market, as implied by the continued sluggish rate of wage gains of just over 2%. Or that its favored inflation measure, the so-called core personal consumption deflator, running at just 1.4%, doesn’t reflect the price pressures felt by most consumers.
Leaving aside the chasm between how the federal government and the average American view inflation, asset prices show incontrovertible signs of inflation. Undeterred by the FOMC’s plan to pare its balance sheet and thus drain some of the liquidity that has bolstered asset prices, the Standard & Poor’s 500, the Dow Jones Industrial Average and the Nasdaq Composite all ended at records Wednesday.

The corporate credit markets show the effect of ample liquidity even more directly. The spread on Baa-rated corporate bonds (the lowest investment grade) Tuesday shrank to just 2.18 percentage points, according to Evercore ISI. The narrower risk premium is associated with stronger economic growth, which the firm says is reflected in the company surveys and the robust showings in the current earnings-reporting season.
In what still is called the high-yield bond market, yields sank to record lows. The popular iShares iBoxx $ High Yield Corporate bond exchange-traded fund (ticker: HYG) closed just shy of its record price hit in the afternoon. More to the point, its “high yield” is a hair above 5%, which I can’t help but recall is less than what my grandmother’s passbook savings account used to pay. It’s also lower than what Treasury bills yielded prior to the financial crisis, which sent short-term interest rates to zero.
High stock and bond prices equate to easy financial conditions. As mentioned in my weekend column, the rallies in equities and credit produced the equivalent of a 1.25 percentage-point cut in the fed funds rate.
In the latest investment letter from Oaktree’s Howard Marks posted here Wednesday, the perspicacious veteran investor noted four key attributes of this easy environment. Asset prices are high; many investors have taken on risk to reach their returns goals; at the same time, prospective returns are about as low as they’ve ever been. Finally, uncertainties are unusually high, notably for future growth, interest rates and inflation, political dysfunction and the long-term impact of technology.
As for risk, the CBOE Volatility Index, or VIX, is at the lowest level in its 27-year history. The last time the so-called fear gauge was this low was “when Bill Clinton took office in 1993, at a time when there was peace in the world, faster economic growth and a much smaller deficit.” Should investors be equally confident or complacent now?
Fed Chair Janet Yellen says the process of unwinding the central bank’s balance sheet should be as boring as “watching paint dry.” Given the current backdrop of lofty valuations and heightened uncertainty, the unprecedented process of reducing the Fed’s massive holdings could prove to be interesting times, as in the Chinese curse.