Can the Fed Successfully Shrink the Balance Sheet?

6th April 2017

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Summary

• The Fed believes reducing the balance sheet and raising Fed funds are interchangeable
• We disagree - and view the balance sheet as far more potent and hence dangerous
• A reduction would be deflationary leaving markets vulnerable and turbo charging the dollar
• US private sector credit creation is the only solution or we face a nasty downturn in 2018 

With Wall Street economic expectations at their highest level since early 2014, the Fed is finally starting to hang tough. Unfortunately, as usual, the Fed’s timing is appalling and we fear they’ve turned hawkish at the top of the cycle, just as we move into what we’ve dubbed the “Trump Gap”! The good news is this should kill some of their overly aggressive chatter, because at the end of the day, outside the few real hawks this was almost certainly a ruse. We say that because we still firmly believe that they are still pursuing a policy of nominal GDP targeting and will tolerate inflation that’s closer to 3% before they move decisively. In this context, hawkish rhetoric, together with the odd timely hike, are simply ploys to buy them time and prevent a rout in fixed income, as they move behind the curve. We hope this argument also applies to recently heightened threats to run down the balance sheet. We say “threats” because at the end of the day, we believe the balance sheet is such a powerful weapon that unless there are some material changes in US bank credit and lending, we doubt it can ever be used. 

With fed funds at only 1%, it may seem premature to be discussing balance sheet adjustment. However, in the mind of many Fed officials QE has always been interchangeable with rate changes. For example, in 2010 Dudley said: 

“Recent experience suggests that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.” A point reiterated in 2011, when Bernanke said: “We estimate the impact on the whole structure of interest rates from $600 billion is roughly equivalent to a 75bp cut ".  

Using these assumptions, the $3.5tln balance sheet expansion since September 2008 is theoretically equivalent 350 to 525bps off fed funds. Now it’s true, that some observers would say that the effective easing is lower because the Fed’s liabilities (especially the currency in circulation) have also expanded implying a larger balance sheet than in 2008. However, irrespective of the exact number, there’s no question that it’s substantial, and logic dictates that at some point, rather than rely purely on hikes they’d turn their attention to balance sheet reduction. Indeed, with the publication of yesterday’s Fed Minutes, it appears that we should expect the initial move sometime towards the end of the year or at the latest the starts of 2018. The question is, what does this imply for markets? 

 If we start off with bonds, the standard Fed view since the start of the GFC is that QE lowered bond yields. We just don’t agree. Yes, there’s no question that from the start of QE1 in September 2008 until the end of QE3 in 2014, Treasury yields fell from 3.75% to 1.6%. However, CPI also collapsed during this period and we believe this was the main driver. The chart below demonstrates that during QE1, 2 and 3, real 10yr Treasury yields were positive and relatively stable. If QE had worked, as the Fed believes, real yields should have declined. So, why didn’t they? 

We believe that the explanation is simple; US investors treated QE as reflationary and sold Treasuries to buy risk assets, which we’ve illustrated below with stocks. Thus, yields rose not fell during QE.  

This is further supported by the following chart, which shows the rate of change in the Fed’s balance sheet vs. 10yr Treasury yields. It illustrates that yields rose during periods of rapid balance sheet expansion. While post bouts of QE, even a decline in the rate of Fed’s balance sheet expansion (yellow bars), let alone outright contraction, was greeted by a collapse in Treasury yields. 

That brings us to equities and the amazing correlation between the US stock market and the balance sheet. To illustrate the point, below is the broad-based NYSE Composite, which contains all NYSE stocks, ADRs, REITs, tracking stocks, etc. We believe this is a damming chart because it proves that, for all the veneer of credibility that the Fed wraps themselves up in, QE was simply monetary debasement (no different in essence from what occurred in the Weimar Republic or Zimbabwe in the 2000’s). At face value this suggests that the stock market won’t react kindly on any balance sheet contraction.  

The same could be said for credit. The spread between 5yr Treasuries and the iBoxx USD Liquid High Yield Index has fought its way back to a level commensurate with the balance sheet after widening dramatically in 2015. 

Finally, that brings us to the dollar, which is where we are most worried about the potential consequences. As you can see below, under QE1 and 2 the dollar fell markedly. Yet, from 2011 onwards thanks to countervailing action from the BoJ and ECB there was little follow through during QE3. However, what stands out is the size and speed of the move once discussions of tapering started to pick up in the middle of 2014. So why did it move so quickly and so far?  

As we reiterated most recently in our MI2 Spring Video (3rd March), the collapse of the US current account deficit on the back of domestic energy substitution means that there is a structural dollar shortfall at the heart of the reserve system. Thus, as the Fed tapered in 2014, the dollar exploded. The good news, is that as you can see below the relationship between the value of the dollar and our supply model finally appears to have reached a point of equilibrium. 

Unfortunately, this may be temporary, because despite recent setbacks to BAT, Trump officials continue to discuss policies designed to reduce the current account deficit. We will state yet again for the record. This is fundamentally contradictory to the dollar’s role as the global reserve currency and would increase the global dependency on US capital outflows in the form of FDI, Fed swap lines and most significantly, fickle portfolio outflows. As shown on the following chart, these can be quite sensitive to Fed QE.  

Therefore, despite what the Fed may believe, balance sheet reduction and rate moves aren’t comparable. In a system, where the dollar is the anchor currency in countries that make up 70% of global GDP, a supply reduction is more toxic than an increase in the cost of borrowing. Hence, at the mere hint of tapering in 2014, the dollar went parabolic and markets that are sensitive to the dollar supply (EM or commodities) nosedived. This backdrop is precarious enough, but as we explained at the end of last year (“Trump’s Dollar” 28th November), corporate profit repatriation alone, if implemented as planned, will be as incendiary as dropping napalm on a forest fire! Therefore, throw a reduction in the Fed’s balance sheet and it’s not hard to see how we could get a conflagration of global proportions.   

With these potential outcomes, we don’t believe the Fed should even be contemplating reducing the balance sheet. However, there are developments that we hope could significantly mitigate the downside. In this regard, it is important to understand that the Fed is just one element of the whole US liquidity picture. Therefore, in theory, as they reduce their role, the gap can be filled by other players. The most obvious would be US private sector banks who could step up to the plate and increased their domestic as well as overseas lending. Interestingly, this is exactly what Gary Cohn, Director of National Economic Council, is trying to achieve by proposing to reduce restrictions on bank leverage.  

Unfortunately, given Democratic opposition this isn’t an easy hurdle to jump and we fear that Sod’s Law dictates that any Fed balance sheet reduction occurs just as Trump’s policies kick the economy into high gear in late 2017/early 2018. In that scenario, the squeeze on the dollar supply caught between a shrinking balance sheet and corporate profit repatriation could be utterly caustic. Indeed, in the absence of an increased ability by US banks to fill any dollar shortfalls, balance sheet reduction could easily end up deflating a bunch of massively pumped-up assets, especially overseas.  

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