The Fed Unwinding the Balance Sheet: Effects on the ARM Industry

November 21st, 2017

In 2009, the Federal Reserve (Fed) embarked on an asset purchase program to create financial stability within the market and spur growth. Through this process, which more or less lasted until 2015 per the graph below, the Fed purchased trillions of dollars worth of U.S. Treasuries and government-supported mortgage-backed securities (MBS). Last month, the Fed finally began unwinding its $4.5 trillion balance sheet, as stated by the Federal Open Market Committee’s (FOMC) most recent statement. Initially, the Fed would allow securities to mature and not reinvest their proceeds. Additionally, the Fed began selling $10 billion of its asset holdings each month ($30 billion per quarter), growing every quarter by $10 billion in sales per month, until $50 billion of holdings are sold off each month ($150 billion per quarter). However, the balance sheet unwinding may be a huge risk to the economy and markets, as the impact of this event is truly unknown since it’s so new. If the economy doesn’t withstand the unwinding properly and borrowing stagnates too dramatically, or even declines, we may see a slow-down in consumer expenditures, leading to fewer opportunities for the accounts receivable management (ARM) industry.

With the implementation of quantitative easing, the Fed set its baseline rate at a historic low to help incentivize borrowing and personal expenditures. This drove returns on Treasury and federal government securities to fall, and, as yields on bonds decreased, investors sought a new source of return through an alternative asset class. According to Forbes, experts credit the quantitative easing and asset purchase program with inflating the value of financial assets (e.g., stocks). As the Fed reduces its balance sheet, we should expect the value of other financial assets to slowly decline as a result, risking significant economic issues if the reduction turns out to be too much for the financial markets to handle.

As the Fed unwinds its balance sheet, this will test the true strength of the economy, as well as the broader stock market. Should interest rates rise significantly, which they aren’t expected to following Jerome Powell’s recent nomination as the next Fed chairman, stocks may experience a significant pull back, since Fed securities would be increasingly more appealing, as mentioned previously. Additionally, if the Fed does raise its baseline rate more quickly, then economy-wide costs of borrowing should increase as well, slowing economic expansion by indirectly reducing consumption. However, the Fed – including soon-to-be-Chairman Jerome Powell – has taken a very cautious approach to its monetary policy over the past half-decade, and only more recently perceives the economy as being strong enough to withstand these changes.

While the impact of the reduction is truly unknown, the end result should slow economic expansion to some extent, posing a significant risk to the market. The Fed must carefully monitor the economy to observe its reaction to the reduction of its balance sheet, as unwinding too fast could push the economy into a recession. If the economy begins faltering, consumers would be less inclined to take out loans since interest rates will be higher. This should lead to less personal consumption and debt accumulation, hurting the ARM industry soon thereafter. However, one optimistic outcome for the ARM industry if this occurs is that borrowers with adjustable-rate loans and high credit card bills may be more likely to go delinquent on their existing debts, leading to greater ARM opportunities in the short-term.

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