It’s D-Day for The Downfall of the “Easy Money” Market – Here’s What We Can Expect from the Fed

The Fed’s “Soft Landing”

The Fed has done a surprisingly decent job telegraphing their plan to “normalize” or “unwind” their balance sheet.

Telling the market what they plan to do months before they were ready to put the plan into action has given the market time to digest the idea.  We have known what the Fed was planning to do, just not when.

Let’s step back for a moment and remember what got the balance sheet to this bloated level. 

From 2008 to 2014, the Fed bought up billions of dollars in toxic assets from failing institutions as well as trillions in government bonds and mortgage securities, pushing fresh money out to the country’s biggest financial institutions, money then made it back into the system through lending and other efforts.

Buying tens of billions of dollars’ worth of bonds every month adds up – to a cool $ 3.7 trillion (give or take a few billion) between 2009 and 2014.

Right now, the Fed’s “Balance Sheet” – the assets on its books – sits at a whopping $4.5 trillion.

Importantly, since the Fed stopped buying additional bonds of either type in 2014, they have kept the balance sheet at its ultra-inflated level by repurchasing existing bonds as they matured.

What the FOMC has announced as their “plan” is not to actually sell their assets (bonds), but rather they’ll simply not repurchase the U.S. Treasury bonds and mortgage-backed securities at the rate in which they mature.

When they decide to pull the trigger, the Fed has will reduce their reinvestment of maturing bonds by $6 billion of U.S. Treasurys (CQ) and $4 billion of mortgage bonds per month.  Then every three months, this $10 billion per month cap will grow by another $10 billion per month until the reinvestment cap reaches $50 billion per month.

That’s the announced plan, should they decide to stick with it…

The Fed hopes that the combination of not actually selling any new bonds back into the market and the phased approach of reducing expiring bond repurchases will create a “soft landing.”

In short, the Fed would like ideally like “The Great Unwind” to be very boring. 

But the market has other ideas…

What to Expect From the Fed

It’s universally expected that the Fed won’t raise interest rates today. 

In fact, the Chicago Mercantile Exchange FedWatch Tool shows only a 1.4% chance that the Fed will raise interest rates by 25 basis points (or ¼ of a percentage point):

In addition to no interest rate change, most analysts expect that the Fed will announce a start date for “The Great Unwind.”

But as I’ve shown above with only $10 billion of bonds allowed to “mature out” of the balance sheet per month, we’ll really start with something more like “The Barely Noticeable Unwind.”

That’s why the market hasn’t reacted in a negative fashion to the pending news. 

But traders and investors don’t think that this calm market demeanor will last.

The Market’s Great Expectations

We’ve talked before about the Volatility Index, or VIX for short – otherwise known as the “fear index” because it is low when the market is complacent, and grows higher when fear and uncertainty rise.

Right now, volatility is dropping leading up to the big Fed announcement:

Quick Aside: I promised to make you an “insider” during our 10-Minute Millionaire journey together – and that’s exactly what I’m going to do.

Even some of the top traders I’ve talked with over the years don’t know the information I’m about to share with you.

However, there is a virtually unknown measure of volatility that is telling a different story.

The VIX measures the volatility that traders expect over the next month.  It does this by calculating the changes in options premium that traders are required to pay for near-term options.

But there’s a little know index that measures traders’ expectations three months into the future.  And that index shows that traders are paying a significantly higher premium for options that expire three months from now than for shorter-term options.

In short, this chart shows that traders expect volatility to return in the next two to three months with a vengeance. 

In fact, this ratio of short -to- intermediate-term volatility just peaked to the highest level it’s been since 2012. 

Take a look at this chart that tracks this ratio between one month and three-month volatility:

Traders are betting that big changes in volatility are coming. 

And with our 10-Minute Millionaire system, we’ll be ready when they do.

Great trading,

D. R. Barton, Jr.

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