C.J. Lawrence Weekly – “The Great Unwind Begins”

With the arrival of October comes the beginning of the Federal Reserve’s efforts to unwind its’ massive $4.5 trillion balance sheet. The Fed’s chair, Janet Yellen, has expressed her desire to keep the process running quietly in the background. The markets are hoping it plays out that way. Never in the history of the Federal Reserve has such an undertaking been attempted. The plan is for the Fed to stop reinvesting the money that current investments throw off, and then allow $6 billion in Treasury securities and $4 billion in mortgage backed securities to mature every month. At that pace, it would take over nine years to chip off 25% of the Fed’s balance sheet, following only that approach. The pace at which they sell additional securities into the open market will be closely watched for market impact.

On the other hand, household and corporate balance sheets look quite healthy. The recently released Flow of Funds data from the Fed shows household net worth up 1.8% at the end of 2Q17 versus the end of 1Q17, and up 9.3% on a year-over-year comparison. The increase has been driven primarily by higher real estate values and the appreciation in value of securities held by U.S. households. Household debt rose by 3.7% annual rate which is faster than last quarter’s annual rate but slower than the 4.4% pace in 2Q16. Importantly, the Fed’s Household Debt Service and Financial Obligations Ratio, which measures households’ ratio of interest expense to income, held at 15%. This ratio has averaged 16.5% since 1980 and has had peaks above 17.5% in 4Q86, 2Q01, and 4Q07. The current ratio suggests U.S. households are doing a good job keeping borrowing in check.

The Fed’s version of a U.S. non-financial corporate balance sheet shows that asset values of U.S. companies have risen faster than liabilities, creating a higher “net worth” for U.S. companies. Balance sheet cash levels were up 6.8% in 2Q17 from the year-ago period, and debt, as a percentage of corporate “net worth” is now calculated at 37.5%, down from 38.7% last year. While the absolute level of borrowing by U.S. corporations has risen, the interest coverage ratio of the S&P 500 is in-line with its 20-year average, suggesting that managements are doing a good job optimizing their capital structures without getting extended. With corporate and household balance sheets in relatively good shape, the market’s attention will likely stay focused on the Fed’s balance sheet unwind, keeping it in the forefront, rather than in the background, as Chair Yellen had hoped. So far, it appears that investors are optimistic that the Fed can pull it off.

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