Federal Reserve’s $ 8 trillion balance sheet will limit tantrum


Neglected this week amid all the talk about the Federal Reserve launching the process of The fact that the central bank’s balance sheet assets exceeded $ 8 trillion for the first time curtailed its unprecedented stimulus efforts. This step should be a reminder that just because the Fed may soon start cutting, or “cutting” the $ 120 billion per month it has been pumping into the financial system since the start of the pandemic, does not mean that the forces that have the underlying markets are disappearing anytime soon, maybe not for years.

Flood the system

The Fed’s balance sheet assets have reached a new milestone

Sources: Federal Reserve, Bloomberg

The situation could cause the central bank to repeat The Enigma of Fed Chairman Alan Greenspan when the central bank started tightening monetary policy in 2004 only to see long-term bond yields fall, which helped ease financial conditions and rise in equities. We saw a hint of this last week, with the benchmark 10-year T-bill yield falling to some of its lowest levels since early March.

Go down

Bond yields hit their highest of the year

Source: Bloomberg

The first thing to know about the Fed’s debt reduction plans is that it won’t mean that all the money created by the central bank will be taken out of the financial system, or at least not yet. Many strategists would argue that the central bank’s largesse is the main reason riskier assets such as stocks have soared not only during the pandemic, but since the financial crisis more than a decade ago. Placing a chart of the S&P 500 next to another showing the expansion of the Fed’s balance sheet would only reinforce this notion.

The second thing to know is that the central bank has arguably created more liquidity through its quantitative easing measures than the banks know what to do with it. Data compiled by Bloomberg shows banks’ excess liquidity fell to $ 6.74 trillion, from $ 3.21 trillion at the end of 2019 and to less than $ 300 billion before the Fed began to use quantitative easing as part of its policy tools in 2009. reverse repo facility. This program allows financial institutions to park excess liquidity with the central bank. Rarely used in recent years, demand has skyrocketed lately even though the Fed paid 0% interest on the money deposited. (The rate was raised to 0.05% “juicy” this week.)

Too much money on hand

Banks put record amount in Fed repo facility

Sources: Federal Reserve, Bloomberg

Banks also recycle a ton of money into government securities. The growing discrepancy between bank holdings of treasury bills and related securities and the amount of outstanding commercial and industrial loans is blatant, providing further evidence that there is too much money flowing through the financial system.

Opposite directions

Banks invested excess liquidity in bonds rather than making loans

Sources: Federal Reserve, Bloomberg

The key questions are when will the tapering start and how long will it last? The answer is that tapering will most likely begin later this year or early 2022, depending on the strength of the economic recovery, and possibly last until 2023. Federal Reserve Bank of New York investigation market participants and the 24 primary dealers this trade with the central bank revealed that the reduction was to last 12 months, according to Morgan Stanley.

No matter what the Fed does or when it does, there are forces that are expected to keep the cost of money near record levels, not only for the immediate future, but well beyond the end of the cut. Such a scenario should limit any rise in bond yields, which in turn should provide a favorable environment for equities and other risky assets. This is what happened from mid-2004 to mid-2006, when the Fed raised interest rates nine times, from 1% to 5.25%; the S&P 500 and the Bloomberg Barclays US Treasury Index managed to generate positive returns in each of these years. And while 2013 was a terrible year for the bond market as the Fed cut back on buying, resulting in the “Cone of anger”, the S&P 500 actually climbed 29.6%. Additionally, there is much more excess liquidity in the financial system as measured by M2 – which is cash, check deposits, savings deposits, money market funds, and other items defined as “Quasi-money”.

Climb higher

The amount of cash and cash equivalents has jumped since the start of the pandemic

Sources: Federal Reserve, Bloomberg

BMO Capital Markets rate strategists, consistently ranked among the best in the industry in the highly-followed annual Institutional Investor surveys, outlined a number of forces that are keeping yields low in a note to clients on Friday. These include the high yields offered on US Treasuries compared to what investors can get on sovereign debt almost anywhere else in developed markets; the persistent global savings glut; ageing population; technological advances tempering long-term inflation; and the reduction in volatility around interest rates, as central banks have become more transparent about their political intentions. Here’s how they summed it up:

This is not to say that 10-year yields will never hit a 2-handful again, but rather that the prospects for such an eventuality (were) just reduced and will require a longer trail than many in the market would have. could have assumed at the end of the first quarter when (yields) reached 1.77%.

Better than the rest

Yields on U.S. government bonds are higher than those of other developed markets

Source: Bloomberg

For Greenspan, the performance of financial assets as the Fed pulled the punch bowl was an enigma. Now, no one should be surprised if the reaction is the same. The Fed itself took care of it.

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

To contact the author of this story:
Robert burgess at [email protected]

To contact the editor responsible for this story:
Beth williams at [email protected]


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