Finally, the wait is over!  Janet Yellen and the Fed released their plan details for reducing the size of their balance sheet at the September 20^th FOMC meeting.  In the August ALCOTALK newsletter, I prepared readers to expect this decision, and said we would have to wait for the details to judge the future impact of their plan.   In the October newsletter, I will dig deeper into the possible ramifications of this plan.  For now, let’s look at the details of the Feds plan, and summarize what the potential impact for community bankers and the US economy may be.
 
The plan for its balance sheet reduction was laid out as follows; caps will be placed on the maximum dollar amount of mortgage-backed securities (MBS) and US Treasuries that will be allowed to roll off each month.  The caps will start at $4 billion for MBS and $6 billion for Treasuries, and will be raised each quarter, for the next 4 quarters, until they reach $20 billion and $30 billion respectively.   The only question not answered in this plan is the ultimate final size of the Fed’s balance sheet.  Given the political uncertainty of Janet Yellen’s future at the Fed, this decision will likely be made after we know who the next Fed chair will be.
 
Additionally, we were given hints from the FOMC that another rate hike is a possibility at the Fed’s December meeting.  How aggressive the Fed gets with those future hikes is critical in determining the economic impact of the Fed’s future activities.   Below is my “Economic Margin Model.”  It shows that one more rate hike from the Fed will bring the “economic margin” down to zero.  Another hike after that will turn the margin negative, and that, in turn, has negative economic implications for 2019.   What those may or may not be is too early to speculate about.  The good news is the US economy is holding steady, and eventually we will see a pickup in activity due to hurricane rebuilding.  What we really need to see now is a steeping of the yield curve to help our own margins improve.  Stay tuned…


 

Today may mark the most important rate decision in recent times.  It was announced this morning by a top U.K. regulator that it would phase out the London interbank offered rate or LIBOR by the end of 2021.

This will eventually have implications for any of you that use LIBOR as your pricing index for variable rate loans.   You can read more on this here: https://www.bloomberg.com/news/articles/2017-07-27/libor-to-end-in-2021-as-fca-says-bank-benchmark-is-untenable-j5m5fepe

Investing legend Warren Buffett famously said, “After all, you only find out who is swimming naked when the tide goes out.”  Recently, it has become apparent that there is some nudity in the oil patch.  In the first chart below, I compare the price action of the S&P 500 Energy Sector Index, on a relative basis, to the S&P 500 (“the tide,” red and black line), against the price of West Texas Intermediate Crude Oil (“the nude swimmer,” black line).


 
 What is clearly evident, since January of this year, the tide has run out on oil prices.  Energy stocks are sending a warning that the supply demand equation for oil does not lend support for oil at this price level.  One reason oil prices may be at these levels is that the Saudis have their largest oil company going public soon (Saudi Aramco, Co.), and are desperate to raise as much money as possible on the IPO.  High oil prices will help them in that endeavor.  Given the past relationship of energy stocks and oil prices, we can deduce one of two things; either oil prices are too high or energy stocks are a screaming buy.  The two lines will revert back to each other, at some level, at some point in the future.  The last time this happened was in May of 2015 (chart below).  There too, energy stocks underperformed oil prices, and that was a warning of the eventual collapse in oil prices that caused so much turmoil in late 2015 and early 2016.


 
So why do I bring this up?  Well, oil is a big contributor to price inflation.  Oil is used in just about everything that is produced in the world, and if oil prices get cheaper, just about everything gets cheaper.  I believe this is why inflation expectations are down, and thus, why long bond yields are down.  How this performance divergence gets resolved will answer a lot of questions about what happens to interest rates and the shape of the yield curve in the future.  Do we continue to get flatter or do we steepen later this year?  Inquiring minds want to know!