Fed’s balance sheet

Posted By Darren Winters on Jan 16, 2020

Fed’s balance sheet

All eyes are on the Fed’s balance sheet.

With the Fed fund rates near-record low of 1.5 to 1.75%, any meaningful rate cuts to stimulate investment and the economy have been exhausted. Think about it. A quarter-point rate cut has not got much vavavoom. 

So has the Fed run out of firepower, as many commentators believe? 

The answer is no if you think that the Fed’s balance sheet can keep expanding.

Theoretically, the Fed, the world’s central bank by default, can keep creating US dollars to buy whatever asset it wishes. The creation of US dollars and the purchasing of assets, also known as quantitative easing QE, has been repeated and ramped up, particularly over the last decade post-2008 financial crisis. Moreover, because the world’s reserve currency the USD is backed by nothing other than trust and military might the Fed’s creation of dollars is theoretically infinite and that too implies that the Fed’s balance sheet expansion can go to 4 trillion USD and beyond.

The Fed’s balance sheet chart here illustrates that the Fed has been holding approximately 4 trillion dollars of assets since 2014. 

When the Fed’s balance sheet contracted back in late 2018, in other words when the Fed became a net seller of assets, which is also known as quantitative tightening QT, stocks crashed. So a head-spinning, jaw-dropping stock market crash in December 2018, the worse December for stocks since the Great Depression was due to the Fed’s balance sheet contraction, or QT. 

The Fed then panicked and that triggered the Fed’s great pivot.

So the Fed abandoned monetary tightening, QT and went back to doing QE and its rate cut trio last year. As we can see from the Fed’s balance sheet chart the Fed has been actively expanding its balance sheet since 2019 which currently stands at approximately 4.1 trillion US dollars.

Adjustments in the Fed’s balance sheet can have a significant impact on price action and to a lesser extent the real economy.

Can the Fed’s balance sheet keep expanding in practice?

FED's Balance Sheet

QE, the creation of currency by the central bank with the intention to purchase assets debases, or depreciates the currency. I accurately forecasted a US dollar top back in late 2019, but the world’s reserve currency is depreciating from a high exchange value (see US dollar Index). 

So a weaker dollar at this level is probably desirable because it stimulates US exports and it makes servicing ballooning US-denominated debts outside the US more affordable. A weaker US dollar provides the world economy with more liquidity.

Excessive risk-taking in the market, rather than a US dollar depreciation is likely to make Fed chair Jay Powell to consider contracting the Fed’s balance sheet

Here is a clue from the October 2012 FOMC meeting, which gave the impression that Fed chair Powell was about to burst the biggest asset bubble in history.

“I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy,” said Fed Powell.

Then came Fed Powell’s explicit admission that the Fed’s balance sheet expansion could eventually lead to trouble ahead

“I kind of think that a large balance sheet might prove to be a magnet for trouble over time, and those two considerations pull me in opposite directions, I admit. So I tentatively land on a floor system with the smallest possible balance sheet. But that brings you to the really interesting question, I think, that Governor Tarullo and Governor Stein were all over, and that is the use of the balance sheet for financial-stability purposes. Very, very interesting questions and I don’t have a lot to add on them here today, but I think those are the things we are going to be talking about for years to come” said Fed chair Powell. 

But despite Fed chair Powell being mindful that expanding the Fed’s balance sheet through QE would inadvertently create an environment of excessive risk-taking the Fed continued under his watch, seven years later, with just that more QE.

So in Fed Powell’s words, The Fed is “blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road.”

The fixed income market is the bond market and with the Fed buying no doubt risky corporate bonds that have attracted a lot of speculative capital in the high-risk bond market, junk bonds. Junk bonds have become attractive in a QE environment because investors are able to profit from the high yields with minimum risk, bearing in mind that the Fed has their backs covered.

The bubble in junk bonds will find its pin if and when the Fed is forced to admit inflation and hike rates. But nobody is forecasting a Fed rate hike for the foreseeable future.

Through the Fed’s balance sheet expansion, the world’s most prominent central bank has underwritten risk

But will that do the inverse of what the Fed is trying to do which is to create market stability? If there is no risk, due to the Fed’s manipulation, will investors go risk all in? 

If risk is disconnected from the market, then price action no longer provides investors with a valuable signal.

By underwriting the market, through the Fed’s balance sheet expansion, the Fed has created a multiple asset price bubble

Conservative investors are being forced to dive into the deep end of risk assets, they are picking up pennies in front of a steamroller.

So at some point, excessive risk-taking will force the Fed’s hand and then the Fed’s balance sheet will start to contract, thereby allowing risk to play its fundamental role in the market again.

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