The Fed Unwind Begins

The Federal Reserve announced an end to its stimulus program this week. It will be gradual but it is likely we see one rate hike by the end of 2017 while the balance sheet reduction begins in October. This is a significant event as it marks the beginning to the end of an era where unprecedented monetary stimulus was used to save the banking system and avoid a deeper recession.

Make no doubt about it, we needed some kind of help from the Federal Reserve in the financial crisis but the size and duration of this program will have its comeuppance. Ultra low interest rates have fueled a vast amount of debt for sovereigns, municipalities, corporations and consumers. It is likely we will see the excesses of all this liquidity rear its ugly head in the coming year as the interest rates rise and sentiment changes. The Fed’s unwind will introduce more volatility into the stock market and credit events into the bond market.

These things take time to bake into the cake so the rally in stocks may continue for a bit longer but I think the end of the road is in sight. Keep in mind the timing of the financial crisis from 10 years ago: The real estate markets topped in 2005, the sub-prime mortgage market began to crack in 2006, the stock market topped in 2007 and finally a crash in equities began in October 2008. This time will be different as politics, currencies and military conflicts are being added to the cauldron of risk brewing outside of central bank policy changes and excess debt.

With volatility comes opportunity. You just have to keep liquid to seize the opportunity.


Economic & Central Banking Snippets

  • Having already laid the groundwork with two interest rate hikes this year, the Federal Open Market Committee (FOMC) took an unprecedented step to tighten its monetary policy Wednesday. As expected, the FOMC confirmed it would begin to contract its sizable balance sheet and shrink its bond portfolio in October. Although this is generally done through the sale of assets and liabilities, the committee is committed to a passive strategy of “ceasing or phasing out the Fed’s current practice of replacing or rolling over maturing assets.” The central bank holds more than $4.5 trillion in assets, largely built during the financial crisis when it began buying long-term Treasuries and mortgage-backed securities. The Fed resolved to pursue another increase in December and projected three additional hikes in 2018, two in 2019 and one in 2020. (FT)
  • Hurricane Harvey is expected to have a meaningful impact on residential building permits in the US. (WSJ)


  • Housing starts came in weaker than expected in August, declining 0.8% to a 1.180 million unit annual rate. Positive revisions to prior months mitigated some of the weakness in August. July housing starts were revised up to a 2.2% decline from -4.8% previously.
  • The 3-month core CPI series changes show the recent bounce in inflation.


  • Japan’s debt-to-GDP ratio hit 245% – this can’t last forever.


Chart Time!


The QQQs is the index to watch as nothing significant has happened in the S&P 500 these past two weeks. If technology stocks break down, the other indices are likely to follow.


Market Snippets

  • Bonds issued by the bankrupt Toys R Us retailer tumbled to a record low as the company’s $400m debt that matures in October 2018 declined to 22 cents on the dollar. The bonds traded hands at roughly 97 cents on the dollar at the start of September.
  • Aerosoles, the women’s shoe company, has filed for bankruptcy, the latest sign of distress in the US retail sector this year. The New Jersey-based company, known for selling comfortable flats in department stores such as JC Penney and its own namesake stores in malls, said it expects the restructuring to take about four months.
  • The US Department of Justice has launched a criminal investigation of the Equifax data breach that exposed personal information including Social Security numbers belonging to 143mm Americans. Authorities are also looking into possible insider trading by three top executives at the credit reporting agency in the weeks before the company disclosed the breach to the public.
  • Twitter said it has taken down nearly 300,000 terrorist accounts between January and June this year, almost all of which were spotted by its internal spam-fighting AI tools. The terrorist-identifying technology is part of a major effort by the social network to push back against widespread criticism by US and European governments that it is not doing enough to disrupt extremist propaganda, allowing its platform to be overrun with trolls and abusive behavior.
  • When Aurora, Ill., closed its books in December, about $150 million disappeared from the city’s bottom line. The Chicago suburb of 200,000 people hadn’t become poorer. Instead, for the first time it recorded on its balance sheet the full cost of health care promised to public employees once they retire. States and cities around the country will soon book similar losses because of new, widely followed accounting guidelines that apply to most governments starting in fiscal 2018. The new Governmental Accounting Standards Board principles urge officials to record all health care liabilities on their balance sheets instead of pushing a portion of the debt to footnotes. The adjustments will show that U.S. states as a group have promised hundreds of billions more in retiree health benefits than they have saved up. The shortfall amounts to $645 billion, according to a new report from The Pew Charitable Trusts based on 2015 data. That is in addition to the $1.1 trillion states need to pay for future pension benefits, according to Pew. The new level of transparency around retiree health expenses for public workers could lower municipal bond prices and force new decisions to reduce or scrap retiree health benefits as a way of coping with ballooning future costs, some analysts and researchers said.


International Snippets

  • From Deutsche Bank strategist Jim Reid: Italy and Japan have seemingly unsustainable debt burdens and are likely vulnerable to a crisis outcome. However both have had this for some time which mitigates short-term risks. Italy is perhaps more vulnerable because of precarious and fragile politics, elevated levels of populism and a central bank that is regional and not domestically controlled. Japan shows how long a crisis can be avoided but that doesn’t automatically mean we should be complacent, especially as the BoJ now owns over 40% of the JGB market (from under 10% in 2012).

  • Chinese authorities are moving toward a broad clampdown on bitcoin trading, testing the resilience of the virtual currency as well as the idea its decentralized nature protects it from government interference. Regulators have decided on a comprehensive ban on channels for the buying or selling of the virtual currency in China that goes beyond plans to shut commercial bitcoin exchanges.
  • Standard & Poor’s lowered China’s sovereign credit rating, joining a growing chorus of alarm over the nation’s soaring debt levels despite government pledges to fend off financial risks. S&P Global Ratings said it downgraded China’s rating to A+ from AA-, while changing its outlook to stable from negative. Fitch Ratings lowered its China rating in 2013 and Moody’s Investors Service did so in May.
  • The U.K. capital’s top transport authority said Uber Technologies Inc. was unfit to hold on to its private-car hire license in the city, threatening a shutdown of the service in one of the ride-hailing company’s biggest global markets. (FT)

Paul McCarthy

Mr. McCarthy is the President and founder of Kisco Capital.