The economy is doing just fine, and now it's time for the Federal Reserve to stop propping things up with things like monthly bond purchases.
That was the big takeaway from minutes of a Federal Reserve meeting in mid-June, released on Wednesday. Starting in October, the Fed will cease buying new treasuries and mortgage-backed securities that are the cornerstones of the latest iteration of an economic stimulus program, known as Quantative Easing.
The program has helped keep interest rates low for investments like U.S. Treasuries and other debt instruments, while it has driven investors to seek higher returns elsewhere, such as in real estate and the stock market. In return, stocks have been on a five-year bull run, and some say the markets are in bubble territory, as shares of some companies are surging despite having no or minimal revenues.
Specifically, the Fed announced it will reduce its monthly purchases of mortgage-backed securities and U.S. Treasuries to $35 billion from $45 billion starting in July, and it will end new purchases completely in October. And while it's hard to judge exactly what will happen come October, here are three likley possibilites:
1. Stock indexes may retract, and some companies could falter.
The end of the buybacks this fall is likely to lead to a stock market drop as investors reassess company valuations in general, experts say. Companies that have allocated cash wisely, made smart business decisions and increased revenues and profits are likely to continue doing well. As for the legion of companies that produce things of questionable value, or that have amassed mountains of debt, they can expect the wind to go out of their sails pretty quickly.
"Most investors have said we have the Fed in place... to help facilitate economic expansion," says Drew Nordlicht, partner and managing director of Hightower Advisors, San Diego. And they've relied on that fact. But as the Fed rethinks its policies, investors will similarly rethink their attitudes toward the stocks that aren't necessarily on sound footing. For instance, companies that have engineered their prices based on the Fed's favorable programs might lose steam, notes Nordlicht.
The move could also affect which and whether companies can go public. As money is less abundant and investors reassess risk, giant IPOs like we've seen with Facebook and Twitter could be a thing of the past.
In truth, the Fed is not disappearing from the scene entirely. Currently the Fed owns $4 trillion of U.S. Treasuries and mortgage-backed securities, with about $1.5 trillion of that added during the last few years of bond repurchases. When the Fed stops buying in October, it will still hold those investments, from which it earns interest of about $90 billion annually, says Nordlicht. The Fed can use that interest either to provide additional liquidity to the Treasury, or it can continue to purchase bonds without adding to its balance sheet, Nordlicht adds.
2. Rates might rise, along with businesses' borrowing costs.
For her part, Federal Reserve Chairwoman Janet Yellen said in June that the removal of the Fed as a prop in October might not coincide with an immediate increase in its federal funds rate, which has hovered near zero since the financial crisis began. The federal funds rates sets the rate at which banks borrow from one another, and it is the underpinning for the loan rates banks set for businesses and consumers.
Still, the U.S. central bank can only stave off the inevitable for so long. Experts such as Jonathan Citrin, founder of investment advisory CitrinGroup and an adjunct professor of finance at Wayne State University, see trouble for small business owners in what he expects will be the rising costs of borrowing.
The Fed can't raise interest rates while it's simultaneously pushing them down through bond purchases. So by ending the bond purchase program, the Fed is also setting the stage for a higher federal funds rate, Citrin says.
"Eventually rates will go up, and it will be more difficult for people to get money, and the net effect is that will hurt the economy and small businesses," Citrin says. Though, it should be noted that higher rates would promote more saving--and possibly prop up so-called safer investments such as U.S. Treasuries.
3. The economy could retract further.
Meanwhile there are significant, broader risks that can't be ignored, namely that economic growth is weak, and it will be vulnerable without the Fed's active backstop position. Gross Domestic Product growth, which is, generally, the measure of goods and services produced in the economy, has hovered around 2 percent, not the 4 percent the Fed and other monetary experts believe is necessary for an economic expansion. The negative growth rate of the first quarter, partially related to severe weather in the Northeast, also shows how dependent the economy is on external factors.
Consumer spending and use of credit, two key drivers of economic expansion, have also been modest in the past year, Nordlicht says, adding he doesn't think that's likely to change much for the rest of the year.
As the Fed's news reached markets today, key indexes including the Dow, the S&P 500, and the tech-heavy NASDAQ all fell.