Nearly a decade after the Great Recession, the U.S. Federal Reserve is set to begin the colossal task of reducing its $4.5 trillion balance sheet. How it will play out no one knows, but Federal Reserve officials have decided it's time to find out.
Today, the committee is expected to announce it will begin tapering, letting up to $50 billion of Treasuries and Mortgage-Backed Securities (MBS) roll off its balance sheet commencing October. Analysts are debating where investors should put their money, which asset classes will prosper, and which will struggle. In theory, as the balance sheet shrinks, U.S. yields should rally and drag the U.S. dollar higher. And while the stock market may struggle, some areas will prosper. "At the sector level, higher Treasury yields and a steeper yield curve should benefit banks and other Financials stocks," Goldman Sachs wrote in a research note. "Financials’ returns vs. the S&P 500 continue to exhibit nearly the strongest correlation with Treasury yields on record."
Source: St Louis Fed
It has been an up-and-down 12 months for financials. In the wake of the 2016 election, banking stocks surged as President Donald Trump pledged to lighten regulation and ramp up stimulus, which drove interest rates higher and in turn pushed U.S. bank stocks to multi-year highs. The KBW Banking Index rose by more than 30 percent in the space of three months as the U.S. benchmark 10-year Treasury yield hit 2.5 percent for the first time since September 2014. However, sentiment has since waned. "After outperforming their macro drivers on hopes of deregulation in late 2016, bank stocks have now given back all of their earlier “policy premium,” making them a particularly appealing opportunity, in our view," Goldman Sachs wrote.
Source: Goldman Sachs
Such a monumental change in policy comes with risks. Should investors not buy into the Fed's decision and the bond market remains strong, the Fed alarm bells will begin to ring. Evidence of this will come via long-term yields. If they don't rise relative to short-term yields and the curve flattens, then officials will have a problem on their hands. (See also: The Inverted Yield Curve Guide to Recession)
Historically, a flat yield curve has preceded economic instability. Before the Great Recession, the 2s10s - the spread between the 2-year yield and the 10-year yield - headed towards zero as concerned investors seek long-term protection by investing in long-term bonds. Additionally, balance sheet reduction has posed problems in the past. MKM Partners noted that throughout its history the Fed has attempted to reduce its balance sheet six times, and five of these attempts led to a recession with the most recent in 2000.
Whatever the case, the market seems ready for the move, volatility remains subdued, and yields are stable. But that was also the case before Ben Bernanke's 2013 testimony where his one sentence led to the infamous taper tantrum. "The Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year," Bernanke said.
All things going to plan, Bernanke will end up being four years early to the party.