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Fed Holds Interest Rates Steady—Announces Balance Sheet Reduction Plan

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RANDY FREDERICK: Yesterday, the FOMC* concluded its September policy meeting and, as expected, left interest rates unchanged, but there were some important announcements. Liz Ann Sonders joins me for the September 21st Schwab Market Snapshot to give us her take on what the Fed said.

So, Liz Ann, no one was expecting an interest rate hike, but the Fed did announce its balance sheet reduction plan. So can you give us the details of this plan and why they’re doing it?

LIZ ANN SONDERS: First, Randy, to your point, no one was expecting an interest rate increase. Pretty much everybody was expecting the announcement that we did get. And I’ll explain the details in a second, but, first, just a quick refresher. Since the financial crisis, the Fed put together three rounds of quantitative easing—which, ultimately, resulted in what is now a balance sheet valued at about 4½ trillion dollars—with a combination of treasury securities and agency- and mortgage-backed securities. And they’ve been reinvesting the proceeds all along.

Now, what they’re going to start to do is slowly let some of those securities run off. Initially, it will be about 10 billion dollars a month, which, of course, is a small fraction of 4½ trillion dollars, with a 60-40 split between treasuries and mortgage-backed securities. And then every quarter, at least for the next year, they will up that by about 10 billion dollars. So at the end of a year from now they'll be allowing about 50 billion dollars to run off—again, a very small fraction of the 4½ trillion dollar balance sheet.

RANDY: Well, now, it seemed to me that, initially, the markets didn’t know what to take of Janet Yellen’s comments. First, bonds and stocks both sold-off, and then they turned right around and rallied into the close. It seems like, normally, she’s either viewed as being hawkish or dovish. So what was it in her commentary that caused such a quick turnaround?

LIZ ANN: So I don’t think it had anything to do with the announcement per se because that was very much expected. What I think maybe, initially, shook markets a little bit is that the statement was perceived to be more hawkish than what was expected. Given that most members of the FOMC support the idea of at least one more interest rate increase between now and year-end.

Now, we’ve been in that camp all along, but it really sort of put the nail in the idea that a December rate hike is on the table. So I think that knee-jerk reaction by the market was, “Boy, we’re not only getting now this beginning of quantitative tightening, but we’re going to get traditional tightening by virtue of another rate hike at year-end.” But then the realization that rates are rising from a very low level. There’s still a massive amount of global liquidity. This is a very small step toward normalization. Those things were seen as more positive longer-term.

RANDY: Yeah, that makes a lot of sense. Now, let’s go back and revisit the first topic again. Now that we know the details of the Fed’s balance sheet reduction plan, what can we expect from stocks and bonds going forward?

LIZ ANN: So I’ve mentioned the liquidity support under the market, which has really been the most important support for this entire bull market. Now, the good news is, is even though the Fed has taken this baby step toward normalization, other central banks globally are still pumping a massive amount of liquidity and more than offsetting the drain that is going to come from the Fed.

Even a year from now, when the Fed is allowing a 50 billion dollar a month shrink, that’s still less than what the Fed was adding to its balance sheet before the taper began in 2014. So this is still very much a liquidity story. Yes, the balance sheet has been put on a diet. I forget who referenced this, but I thought it was a good one, but it’s like giving the person on the diet two desserts instead of three. So this is really a baby step and shouldn’t really upset the apple cart in terms of what has been an important driver for this bull market.

RANDY: Thanks so much, Liz Ann, that’s a great way to look at it. Listen, if you want to read more from Liz Ann you can do that in the Insights section of Schwab.com. You can follow her on Twitter @LizAnnSonders. And, of course, you can always follow me on Twitter @RandyAFrederick.

We’ll be back again. Until next time, invest wisely. Own your tomorrow.

*Federal Open Market Committee

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions.

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