— This is the script of CNBC's news report for China's CCTV on September 21, Thursday.
As what was expected, the Fed's overnight announcement was to reduce its $4.5 trillion balance sheet, officially starting from October. This would be the first time since after the financial crisis that the Fed is reducing its balance sheet.
First, let us understand what it means to reduce the balance sheet. As we know, ever since the implementation of quantitative easing since the last financial crisis, the Fed had bought a large number of bonds and MBS (Mortgage-backed securities) to inject liquidity into the market.
These bonds, which have been accumulating on Fed's balance sheet, have been reinvested to keep their assets at about $4.5 trillion. In simpler terms, the Fed actually created a sum of money to buy bonds out of thin air. Now the Fed would also destroy them in the same manner. But if it is done too quickly, it will cause a huge blow to the market. This is why the Fed has always stressed that the process of reduction must be gradual.
The plan, announced overnight, will begin at $10 billion a month, including $6 billion in bonds and $4 billion in mortgages. And after deducting these expiring bonds, the leftovers will be reinvested. Gradually, it is scheduled to increase by $10 billion every three months. Currently, the Fed plans to do so until it reaches $50 billion monthly reductions in October 2018. Why is the Fed so adamant about tapering its balance sheet now?
In an interview, analysts said that the Fed cannot always maintain such a large-scale balance sheet. Currently, the US economy is stabilizing and the financial markets look healthy. All these point to a good time for balance sheet tapering. Before announcing for balance sheet tapering, some people worry that this will lead to panic and turbulence in the market. This is because, in early 2013, when the Fed showed signs of cutting back on its debt purchase plan, it triggered a sharp decline in the market, known as the "tapering tantrums." But currently, we have not seen these tantrums which indicate that this time round, the Fed has successfully communicated to the public that everything is well within its plan.
After the Fed's announcement, the US stocks fell drastically. But, other than the Nasdaq, the Dow and S&P500 closed up slightly. The US treasury prices fell, its yields rose, of which the US two-year yields climbed to the highest level since its highest level in 2008. All this while, the short-term dollar index rose, with gold prices diving down.
Analysts told us that the rate hike and balance sheet tapering are all expected so it might not be the factor that led to the big correction of US stocks. Instead, it should be due to the earnings not being able to support current market cap, resulting an inevitable correction of the current bull market. Therefore, it is difficult to predict which would have a greater impact on the market liquidity; the rate hike or the tapering.
[Hugh Johnson] "The real problem is I think everybody knows instinctively they believe the markets had a real run, not just in 2017 but in 2016, so common sense alone suggest that maybe we will have to give some of them back or a decline, if you really crunch the numbers though, if you really look very hard at these numbers, it's really very hard to make the case for anything but a correction in stock prices. It is hard to make the case for the kind of earnings that will support stocks at current levels."
The initial impact is limited, but with tapering gradually rolling out, one still needs to remain vigilant about its long-term impact. In terms of a mid to long term period, the tapering will directly affect the supply and demand of U.S. treasury bond. Bond yields may go higher and the bond yields are one of the important benchmarks of global asset pricing. Additionally, the tapering will also tighten dollar liquidity, creating currency appreciation pressure to the dollar. Also, taking into dollar-pegged assets and other factors, emerging markets may face a greater devaluation of its currency and possibly some capital outflow challenges. We will continue to keep watch.
CNBC's Qian Chen reporting from Singapore.