The Impending Federal Reserve Balance Sheet Reduction
As we approach our first FOMC Meeting of 2022, we are faced with the growing possibility that this may not be the same Federal Reserve that we remember from 2021. How do we know this? Because varying members of the Federal Reserve won’t shut up about it. Now that Jerome Powell has officially received his renomination and finds himself once again at the wheel of the SS Titanic, we suddenly cannot seem to find our market sugar daddy anywhere. Powell has seemingly gone from Market grandmother who hands you a crisp $100 bill whenever you see her, to a shrewd, stingy, curmudgeon that complains that you still owe him $10 from years ago. Over the weeks (and frankly months) we have consistently heard the hawkish members of the Fed squawk about the need for a more aggressive tightening of monetary policy. With the market pricing in the likelihood of 4 rate hikes in 2022 (God help us if true), we have lately started hearing our first rumblings about the reduction of the bloated balance sheet this Federal Reserve has hidden in the back of its’ closet.
Yes, believe it or not, the Federal Reserve Balance Sheet CAN go down in size, though it may drag the market kicking and screaming with it. For those who are scratching their heads at what this is all about, let me first make sure we are all on the same page here in terms of the contents of this Balance Sheet Bonanza.
The Federal Reserve Balance Sheet Assets:
As of March 2021
- 60% ($5 Trillion) of the $7.69 Trillion in Assets the Fed owned were US Treasuries.
- $2 Trillion were in mortgage-backed securities (remember those fun toys?).
- The rest was loosely in loans to member banks through repo & discount windows (irrelevant)
The Federal Reserve Balance Sheet Liabilities: DOLLA DOLLA BILLS used to buy those assets
As of March 2021
- $2 Trillion in currency notes
- $5.3 Trillion in deposits
Ever since Covid crawled its’ way into our hearts and minds the Fed ratcheted up its’ buying of Government Securities and has inflated its’ balance sheet to staggering heights. Below is a nice little representation of the growth in Fed Assets since 2008 (when we tried QE for the first time). This chart comes from https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
Did QE even work? That is a whole other question for another time and another bottle of whiskey, though most signs point to a resounding NOPE. But for now, let’s talk about 1. How the Fed can reduce its balance sheet 2. How much should it reduce by? 3. What the impact of this could be.
How can it reduce its’ balance sheet?
There is two main ways the Balance Sheet of the Federal Reserve can shed some pounds. It can allow its’ treasuries and securities to reach maturity and, instead of then reinvesting/rolling over the funds into new securities, keep the cash out of circulation (thus reducing its’ assets and liabilities). Or it can actively sell those securities back into the secondary market. Now each is obviously differing in how aggressive they want to be. To sell those securities back into the market could…complicate things. There is a little thing called supply and demand to worry about and if they flood the market with treasuries, they could cause a nice little explosion in rates. However, some argue that since the yield curve has been flattening, and many of the securities in the Fed’s backpack are long-dated, they should sell their longer maturities to try to raise long-term rates. IF the Fed is going to reduce its balance sheet, we still have no idea HOW they are going to go about it. Maybe we will start to know more on January 26th after the next Fed meeting.
I do want to note that the Federal Reserve HAS tried this maneuver once in the past….and only once. In October 2017 the Fed started a runoff (albeit in a mouse-sized portion) of $10 Billion a month. Over the course of 2018 and 2019, it managed to gradually raise this and managed to lose some weight in the size of $600 Billion; a paltry sum compared to what we need to shed now. At this time markets were…..mixed. Eventually, the Fed had to stop this runoff in the face of mounting market pressures and due to overshooting the drop in Bank Reserve Balances and resume asset purchases.
So, if we end up deciding to lose some dead weight, how much should we lose? Well, the average from what I am seeing (and what Goldman Sachs Analysts seem to agree upon) is a new Equilibrium of $6.4 Trillion in assets (we currently sit at almost $9 Trillion). This would bring us from a whopping 36% of nominal US GDP back to the pre-covid levels of 21%. Now what I have seen from Goldman (and frankly I am not even going to try to attempt to do the mental math and brain gymnastics required to come up with my own number) is that for every 1% of GDP in asset runoff/sales we should experience a 2 Basis Point Rise in the 10-year Treasury Yields. So (and this is about the best math my candlestick-soaked brain can muster) for the 15% of nominal GDP in assets we need to lose, that should move the 10-year about 30 Basis Points. This would have roughly the same impact on rates as 1 rate hike. If you want to see a picture of Goldman’s Public Calculation, I left it below.
Now, who knows what our market’s overlords will decide to come to the FOMC meetings. But I can promise you this, the market is NOT the economy. And it is NOT the rates. The market is a whole other beast, and we may say a temper tantrum from the market as a result. And despite what your magic eight ball might make you think, no one knows where this market will go. This is a year that we expect volatility to spike and risk management to be essential. So we are going to have to play doctor and continually take the market’s temperature to determine how hot-headed our stocks are getting. But don’t expect the market to be thrilled about any Fed action that takes free money from them. The market may attempt to find the new Powell put (the point at which he will turn the money spicket back on). Only time will tell. All I can assure you is that this is going to be a hell of a ride.