The Investment Impact of a Contracting Fed Balance Sheet

(An abridged version of an article published by ClearMacro in their monthly strategy document ClearStrategic. A full version with investment conclusions and charts can be obtained from [email protected])

Global liquidity conditions have been tightening. This statement might seem strange given acceptable credit growth, but “credit counts and money matters”.

Liquidity crises can rapidly morph into credit events unless central banks respond quickly. At a minimum, even if there is no credit event over the next few years, the imminent shrinkage of the Fed balance sheet is going to put upward pressure on long-term bond yields. Rising Treasury yields will, in turn, have far reaching consequences for equities which are overvalued, with other central banks also following the Fed’s lead over the next year.

Unfortunately, a rapid structural change in the global financial system and past policy is going to complicate their task. A reduction in capital controls and expanding world trade along with QE has driven a growing integration of the global economy. As a result, correlations across global bond markets have been rising, and countries operating flexible exchange rates are losing their monetary independence.

Reduced autonomy was never meant to happen in theory, but as the BIS has recently observed it is not just interest rates which are impacted (1). The correlation of credit growth across countries and almost all asset classes has also been increasing, which is a direct consequence of the collapse in volatility. There is now an exaggerated confidence in the power of the central bank balance sheets which could rapidly unravel if they miscommunicate or make a mistake.

The Fed is probably the most challenged because there seems to have been a perpetual surplus global demand for dollars since it stopped expanding its balance sheet at the end of QEIII in October 2014. And now, as it prepares to go one stage further and start reducing the size of its balance sheet, it is generating fears of a repeat of the 2013 taper tantrum, causing us to ask four interrelated questions:

• Can the Fed reduce its size without creating a liquidity squeeze that prompts a credit event and an equity bear market?
• How much will the shrinkage add to the term premium of 10-year Treasuries?
• Will the dollar resume its bull market as the monetary base contracts?
• How will the end of the bout of dollar weakness impact the Bank of China which may now be forced to tighten policy?

Liquidity and the Markets

There has always been a cause and effect argument in examining liquidity cycles. The classic explanation is the portfolio balance effect. Money holdings which are above desired levels prompt a switch into equities and other financial assets, and vice-versa when balances are inadequate. The international version suggests that every time there is a risk-off phase demand for the dollar rises.

So, what if the financial environment deteriorates, the international portfolio effect takes hold, and the Fed keeps on shrinking its balance sheet? The U.S. currency would rise sharply, profits and exports would fall, and the domestic economy would suffer from the loopback effect of an international liquidity crisis.

Of course, it is a hypothetical question, and we must assume that the Fed knows what it is doing and would provide the currency to meet the demand. But it cannot be taken for granted that the U.S. central bank would be allowed to react in an appropriate manner. In mid-2015, it met with an outraged domestic response when it suggested it had delayed raising interest rates because of concerns over the emerging markets. And since then, the protectionist drum under Trump has gotten a lot louder.

At a minimum, therefore, the risks in the international financial markets have increased. Critical in the whole process will be the messaging the central bank adopts and the leeway it gives itself for reversing or staying its hand by lowering interest rates if monetary conditions threaten financial stability. The longer the process of the balance sheet and interest rate normalization continues without any type of crisis, the greater the optionality the Fed will have to adapt to a dislocation.

The Fed has set out a very clear timetable and plan for rolling off assets, shrinking the balance sheet by around $2 trillion over the next 5 years, which is almost exactly equal to current excess reserves. It has also effectively transferred its commitment on zero bound interest rates which it abandoned in favor of its dot matrix which is effectively a forecast, to another commitment on shrinking the size of the balance sheet.

The tricky part of this exercise, however, is less the reduction in reserves, but ensuring there is a steady increase in currency in circulation for which demand has been increasing at a steady pace of over 5% per annum over the past few decades. A calculation by the Fed earlier this year estimated that the demand for currency would grow by $2.5 trillion over the next decade2. Hence the decision to reduce the balance sheet by only $2 trillion over the next five years versus the $3.6 trillion expansion since 2008.

The Term-Premium Effect

So far so good. But critical to the impact on financial markets will be the behavior of the term premium on the 10-year Treasury.

Prior to the Great Recession, reserves held at the central bank had been falling since the early 1990s, as requirements were eliminated on some bank liabilities and reduced on others. Depository institutions held minimum excess reserves, and the Fed influenced the Fed funds rate directly by open market operations.

Post-2008, the Fed balance sheet has exploded, and its composition has changed substantially. Instead of Treasury bills, it now consists mainly of long-term Treasuries and mortgage-backed securities, which are funded by excess reserves held by the banks. The Fed, in turn, influences the reserves held with it by paying interest on excess deposits and through overnight reverse repurchase agreements which encourage money market funds and the GSEs to lend to it. These overnight repurchase agreements effectively define the lower bound of interest rates, while the interest rate on excess deposits held by the banks sets the top.

Herein lies the first dilemma, because the size of the balance sheet must be big enough to ensure that the Fed can set a zero-interest rate as the lower bound. This will be a matter of trial and error and will only be apparent after the fact. More to the point because the Fed has been buying up long-dated Treasuries, the term premium has turned negative. As these assets roll off the balance sheet, the captive market for longer-dated debt should dry up. On our calculations, this should add at least 70 points to the 10-year Treasury ceteris paribus if the term premium mean reverts to the average of the last two decades.

The Impact on The Dollar

The combination of higher rates and a reduction in the size of the Fed balance sheet should also reverse the recent bout of weakness in the U.S. dollar. While the expected combination of tighter monetary and easier fiscal policy has not materialized in the wake of Congressional obstacles to Trump’s legislative agenda, ongoing political uncertainty along with tighter monetary policy should start supporting the greenback.

Ultimately, a rising dollar can be considered an indicator of insufficient global liquidity and, as highlighted earlier, the Fed will need to be alive to the need to accommodate it unless it wants a liquidity crisis.

Moreover, while the liquidity crunch may not happen over the next year, the combination of a stronger dollar and higher interest rates will test U.S. equities which are trading at elevated levels.

China’s Dilemma

Nearer term it is China which poses the bigger risk. A weaker dollar has bailed it out of its earlier problems which saw it leaning into the depreciation of the overvalued Renminbi late last year to restrain rising inflationary pressures in the economy centered around the housing market. At its peak, the currency was over 30% overvalued on an effective exchange rate basis, and while it has subsequently fallen, it is still 13% too expensive based on relative price levels prevailing in 2010.

This overvaluation manifested in two ways: a decline in the central bank assets led by the foreign exchange reserves as it sold forex for the renminbi to support the yuan, as well as a deterioration in the current account. From a peak of nearly 12% of GDP in 2007, the current account surplus has subsequently dropped to 1% and extrapolating current trends could see it tumble into deficit over the next few years.

Recently the weakness in the U.S. dollar has taken some of the pressure off the central bank, and foreign assets have ticked up marginally, but there are enough inflation concerns emerging to suggest that this mini-upcycle in Chinese activity will peak in response to an imminent tightening in monetary policy. Periods when the U.S. dollar has been rising, have typically been associated with capital outflows from the EM, and we see no reason why this time will be any different.

References:

1 “A Primer On ‘Global Liquidity” E Cerutti, S Claessens, L Ratnovski BIS June 8, 2014

2 “Confidence Interval Projections of The Federal Reserve Balance Sheet and Income” E.E. Syron Ferris, SJ Kim and B. Schlusche FEDS Notes February 2017