What Does the Federal Balance Sheet Mean and What's the Impact on You?
The other week the Federal Reserve announced their plan to start unraveling their 4.5 trillion dollar balance sheet. Additionally, they declared that short term interest rates will remain unchanged for the time being. So, what does this actually mean and what impact does it have on you and your retirement preparation?
How did we get here?
In the aftershock of the 2008-2009 recession, the Federal Reserve (basically our nation’s central bank) injected a safety net into our economy. They purchased trillions of dollars of government bonds and mortgage backed securities. For nearly ten years, they’ve continued to reinvest the proceeds as these bonds came to maturity. This process has led to the Federal Reserve building and maintaining a very large balance sheet.
Concurrently to this bond buying program (referred to as Quantitative Easing), the Fed has gradually lowered its short-term interest rate. As of 2016; however, they’ve started increasing this rate again (and have already done two rate increases this year in March and June).
Why did it help?
Many, including myself, believe these tools were paramount to saving our economy. But, why were these two tools so effective?
Purchasing mortgage back securities was a way of securing the real estate market. It offered safety against defaults and took the risk away from banks, investors, and individuals. This, along with purchasing government bonds, injected cash back into our banking system.
Banks with lots of cash enticed individuals to borrow by lowering rates. They did this because they had less incentive to keep cash due to low short term interest rates. When interest rates are so low, there is little incentive to put cash in the banks. We, therefore, saw a massive increase in spending, investing in the stock market, and borrowing for real estate or business ventures. All this served as a catalyst to rejuvenate our economy.
What’s the plan?
Now comes the tricky part – how do they unravel all of this to normalize their balance sheet while not causing a negative shock to the economy? The Fed has to be very careful about its movement while also remaining nimble enough to adjust as needed. They’ve already begun this process by increasing short term interest rates. They are predicting one more later this year and three more increases in 2018. Hopefully the economy is strong enough to handle these higher interest rates as the Fed reiterated that their long-term target Federal Funds rate is somewhere between 2.5-3%.
The other major announcement was to start unwinding their massive balance sheet. The Fed intends to start slow, letting $10 billion a month roll off their books. Eventually, they’ll be increasing it to $50 billion a month. This should have the opposite effect of purchasing bonds (less money in the economy). If you remember your first economic class “supply=demand.” Thus, when there is less money out there the demand (or cost) goes up.
The Fed will always hold substantial assets, so there is no real fear that they unravel to zero. Rather, the plan is to let free markets stand on their own two feet by having less manipulation from the Fed.
What’s the impact on me?
It’s easy to see the impacts of interest rates being low – 15 million jobs added since the recession and one of the longest economic expansions in history. With the recent news about unraveling the Fed’s balance sheet; however, the following thoughts for our clients, their families, and friends should be considered.
- Interest rates should increase in the borrowing market.
Recommendation: If you need to borrow money, or refinance some old debts, now is probably as good a time as ever.
- Stocks and bonds will be affected. Unfortunately, no one really knows how. By going slow, the Fed is trying to provide the least amount of wrinkles through the markets as possible. That said it’s inevitable something this large will have an impact.
Recommendation: Look at your diversification. This is exactly why we diversify; to protect and insulate ourselves from any one segment prohibiting us from reaching our goals.
- The real estate market will be impacted as rates increase. Average purchasers will have to spend less on homes when the rates go up. This can have two outcomes. One is housing prices become cheaper as an entire purchasing pool can afford less. The other is the housing market may continue as is if inflation continues to picks up.
Recommendation: Don’t let the unknown drive a rash decision. A home is a major purchase and I’d hate to see anyone rush on speculation. (For more information on buying readiness, check out Purchasing a House). But, if you are ready to purchase, you might as well. Rates are still historically low.
- Inflation should continue to increase and ideally land at the Fed’s 2% target. With the U.S. labor market being tighter than it’s been in years, it’s surprising that inflation hasn’t been higher. Economists want a 2% level of inflation in an economy. That suggests an expanding economy at full employment.
Recommendation: Bonds typically have a fixed coupon payment, so they carry purchasing power risk since increasing inflation can erode their interest payments. We recommend utilizing a mixed bag of bond instruments. For investors with considerable assets invested in fixed income (bonds), consider using TIPS for a small sleeve as their coupons can increase as inflation rises.
The interesting times ahead
It seems we are getting much more accustomed and immune to unprecedented policy in our economy. We have done a great job as a country of persevering through the best and worst of times. Through the continued “normalization” of the Fed’s policy and balance sheet over the next few years, it should present opportunities and challenges alike. Just make sure you stay educated and keep a long term view.v
Here’s Why Bitcoin Won’t Replace Gold So Easily
What a week it was.
First and foremost, I’d like to acknowledge the horrific mass shooting that occurred in Las Vegas, the deadliest in modern American history. On behalf of everyone at U.S. Global Investors, I extend my sincerest and most heartfelt condolences to the victims and their families.
The memory of the shooting was still fresh in people’s minds during last Tuesday’s Hollywood premiere of Blade Runner 2049, which nixed the usual red carpet and other glitz in light of the tragedy. Before the film, producers shared poignant words, saying that in times such as these, the arts are crucial now more than ever.
I had the distinct privilege to attend the premiere. My good friend Frank Giustra, whose production company Thunderbird Entertainment owns a stake in the Blade Runner franchise, was kind enough to invite me along. Despite the somber mood—a pivotal scene in the film even takes place in an irradiated Las Vegas—I thought Blade Runner 2049 was spectacular. Even if you’re not a fan of the original 1982 film, it’s still worth experiencing in theaters. Hans Zimmer and Benjamin Wallfisch’s synth-heavy score is especially haunting.
CNET recently published an interesting piece examining the accuracy of future tech as depicted in the original Blade Runner, from androids to flying cars to off-world travel read the article here.
Still in the Early Innings of Cryptocurrencies
Speaking of the future, I spoke on the topic of the blockchain last week at the Subscriber Investment Summit in Vancouver. My presentation focused on the future of mining—not just of gold and precious metals but also cryptocurrencies.
Believe it or not, there are upwards of 2,100 digital currencies being traded in the world right now, with a combined market cap of nearly $150 billion, according to Coinranking.com.
Obviously not all of these cryptos will survive. We’re still in the early innings. Last month I compared this exciting new digital world to the earliest days of the dotcom era, and just as there were winners and losers then, so too will there be winners and losers today. Although bitcoin and Ethereum appear to be the frontrunners right now, recall that only 20 years ago AOL and Yahoo! were poised to dominate the internet. How times have changed!
It will be interesting to see which coins emerge as the “Amazon” and “Google” of cryptocurrencies.
For now, Ethereum has some huge backers. The Enterprise Ethereum Alliance (EEA), according to its website, seeks to “learn from and build upon the only smart contract supporting blockchain currently running in real-world production—Ethereum.” The EEA includes several big-name financial and tech firms such as Credit Suisse, Intel, Microsoft and JPMorgan Chase, whose own CEO, Jamie Dimon, knocked cryptos a couple of weeks ago.
To learn more about the blockchain and cryptocurrencies, watch this engaging two-minute video.
Will Bitcoin Replace Gold?
Lately I’ve been seeing more and more headlines asking whether cryptos are “killing” gold. Would the gold price be higher today if massive amounts of money weren’t flowing into bitcoin? Both assets, after all, are sometimes favored as safe havens. They’re decentralized and accepted all over the world, 24 hours a day. Transactions are anonymous. Supply is limited.
But I don’t think for a second that cryptocurrencies will ever replace gold, for a number of reasons. For one, cryptos are strictly forms of currency, whereas gold has many other time-tested applications, from jewelry to dentistry to electronics.
Unlike cryptos, gold doesn’t require electricity to trade. This makes it especially useful in situations such as hurricane-ravished Puerto Rico, where 95 percent of people are reportedly still without power. Right now the island’s economy is cash-only. If you have gold jewelry or coins, they can be converted into cash—all without electricity or WiFi.
Finally, gold remains one of the most liquid assets, traded daily in well-established exchanges all around the globe. Every day, some £13.8 billion, or $18 billion, worth of physical gold are traded in London alone, according to the London Bullion Market Association (LBMA). The cryptocurrency market, although expanding rapidly, is not quite there yet.
I will admit, though, that bitcoin is energizing some investors, especially millennials, in ways that gold might have a hard time doing. The proof is all over the internet. You can find a number of TED Talks on bitcoin, cryptocurrencies and the blockchain, but to my knowledge, none is available on gold investing. YouTube is likewise bursting at the seams with videos on cryptos.
Bitcoin is up 350 percent for the year, Ethereum an unbelievable 3,600 percent. Gold, meanwhile, is up around 10 percent. Producers, as measured by the NYSE Arca Gold Miners Index, have gained 11.5 percent in 2017, 23 percent since its 52-week low in December 2016.
Look Past the Negativity to Find the Good News
The news is filled with negative headlines, and sometimes it’s challenging to stay positive. Take Friday’s jobs report. It showed that the U.S. lost 33,000 jobs in September, the first month in seven years that this happened. A weak report was expected because of Hurricane Irma, but no one could have guessed the losses would be this deep.
The jobs report wasn’t all bad news, however. For one, the decline is very likely temporary. Beyond that, a record 4.88 million Americans who were previously sitting out of the labor force found work last month. This helped the unemployment rate fall to 4.2 percent, a 16-year low.
There’s more that supports a stronger U.S. economy. As I shared with you last week, the Manufacturing ISM Purchasing Managers’ Index (PMI) rose to a 13-year high in September, indicating rapid expansion in the manufacturing industry. Factory orders were up during the month. Auto sales were up. Oil has stayed in the relatively low $50-a-barrel range, which is good for transportation and industrials, especially airlines. Small-cap stocks, as measured by the Russell 2000 Index, continue to climb above their 50-day and 200-day moving averages as excitement over tax reform intensifies.
These are among the reasons why I remain bullish.
One final note: Speaking on tax reform, Warren Buffett told CNBC last week that he’s waiting to sell assets until he knows the plan will go through. “I would feel kind of silly if I realized $1 billion worth of gains and paid $350 million in tax on it if I just waited a few months and would have paid $250 million,” he said.
It’s a fair comment, and I imagine other like-minded, forward-thinking investors, buyers and sellers will also wait to make huge transactions if they can help it. Tax reform isn’t a done deal, but I think it has a much better chance of being signed into law than a health care overhaul.
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