We’ve had seven client/consultant/prospect speeches and meetings in the last week. The hottest topic has been the Federal Reserve’s balance sheet and what changes in it will mean for markets.
Here are some points to consider. Some are retrospective, and some are prospective and therefore conjectural. Warning: This is a 12–15 minute read.
Until the financial crisis the size of the Fed's balance sheet was predictable. The Fed held Treasury bills and notes and some small minor things like gold certificates. (The Treasury has the gold; the Fed holds a certificate valued at an historical $42 per ounce.) Those were the assets.
The liabilities of the Fed were the bank reserves required by the US banking system to be held at the Fed, plus currency in circulation. Reserves deposited at the Fed paid no interest and were rarely in excess of mandatory balances. The increase in required reserves was easily forecast, and the increase in global demand for US currency was easily estimated. Add the two together, and one could predict how many Treasury bills and notes the Fed would purchase. The Fed created the new money to pay for the purchases. That new money became more currency in circulation worldwide and additional required bank reserves. Assets and liabilities were always balanced without any serious alteration in policy.
In those days, Fed policy was applied to the raising or lowering of targeted short-term interest rates, and the target stated by the Fed was (and is) the fed funds rate. That is the interest rate banks pay to each other as they buy or sell reserves on a daily basis. The Fed is trying to get to an Overnight Bank Funding Rate (OBFR) but it hasn't resolved the details on composition and usage.
All that changed eight years ago. An established system that had been implemented for a half century was shocked. Old rules were replaced by a period of trial and error in monetary policy making. Such is the tectonic shift that took place in response to the financial crisis.
In 2007–2008, the Fed instituted a spate of policy initiatives as it sought to avoid a global financial meltdown. Some worked. Some didn't. I could list all the acronyms here, and the list would put readers to sleep.
In 2007–2008, the new policy initiatives weren't working well because the Fed was sterilizing them. It would create new money with one hand and neutralize its effect with the other hand. Hence the balance sheet size remained bound by the ancient concept even as the interest rate went to zero and stayed there.
Wisely (in my view), the Fed didn't opt for negative rates but made zero the floor. Former Fed chairman Bernanke admits that they discussed negative rates but were fearful of unintended consequences after the Reserve money market fund debacle and the post Lehman-AIG meltdown.
In 2009, the Fed launched QE1. The balance sheet grew by over $1 trillion as the Fed ceased sterilization. The world needed US dollars, and the Fed provided them by creating them. Thus the liability side of the Fed’s balance sheet exploded with bank reserves above and beyond required reserves. These were labeled excess reserves, and the Fed paid banks an interest rate on them. Expanding the balance sheet and paying interest on excess reserves represented major changes in Fed policy.
That initial excess reserve payment rate was 0.25%. It became the ceiling rate in a “corridor.” The floor was zero. Between the two was the fed funds rate. Thus a new system and new corridor were born.
Today the ceiling is 1.00%. The floor is 0.75%. Fed funds trade between them. There is also an additional rate for repo (technically called reverse repo), which is managed by the Fed and provides a means for financial institutions that are not banks to place excess money at the Fed.
Thus today the Fed has four major items of liability on its balance sheet. They are currency and required reserves, as before, plus reverse repo and excess reserves.
There is a fifth liability tied to the US Treasury. The Treasury uses the Fed as its banker, so Treasury deposits at the Fed are a liability of the Fed. Thus when Treasury cash balances are impacted by congressional debt-limit issues, the impact can be in the 100s of billions. Remember that the asset side of the Fed is managed independently from changes on the liability side. If Treasury lowers its cash, it forces more cash into excess reserve deposits. This also lowers CD rates at banks, since banks have excess cash and do not have to pay higher CD interest rates in order to competitively attract deposits. An abundance of cash that becomes systemic excess reserves has the effect of lowering CD rates from where they would otherwise be. Such is the case today as the Congress fiddles with debt-limit discussions.
Let's return to the size of the balance sheet. Remember that the first round of QE was an emergency action to add to US dollar liquidity worldwide. It worked.
The second and third rounds of QE were policy initiatives to stimulate economic recovery. Thus with QE2 and QE3 the size of the balance sheet as a policy tool became more than just an emergency action.
Today the Fed knows it cannot impair the world's liquidity needs by shrinking the balance sheet too much or too fast. And today the Fed is gradually restoring the use of the interest rate as its primary policy tool. So the Fed is preparing to alter the size of the balance sheet as early as next year.
We expect the Fed to raise the Fed funds rate again by a quarter point in June and by another quarter point later in the year. The Fed will make those rate rises within the present corridor system. Thus we expect the year-end target for fed funds to be somewhere in the middle and between 1.25% and 1.50%.
Let's get to the balance sheet size and composition.
The Fed currently holds Treasury bills, notes and bonds, a few small items, and a large tranche of mortgage-related securities that are deemed to be riskless and backed by the US Treasury. The Fed would like to lessen its use of mortgage securities and eventually eliminate it. Then the Fed would be back to holding only Treasury bills, notes, and bonds.
There are numerous serious research papers on how the Fed can make this shift. They are all conjectural as to what rate of change the Fed will opt for, how long the transition will take, and where it will end. Separately, there are numerous research papers on what will happen to the US housing market when all this trillion-plus mortgage debt is transferred from the Fed to private market agents. These prognostications, too, are conjectural.
In 2018 the Fed will again find itself in a trial and error period of policy making. It will start a gradual process of allowing mortgage securities to mature and not replacing them with more mortgage securities. It may replace some of them with Treasury bills, notes, and bonds. And it may allow some shrinkage of the balance sheet by not replacing all the maturing mortgages.
Today the Fed is still internally debating the path it will take, and markets are awaiting a policy statement so that market agents can position portfolios accordingly. The Fed has not given us the path, nor has the Fed given us the target size they seek in the future.
The problem for the Fed is that there are many forces in play that didn't exist when they initiated the new corridor and enlarged balance sheet initiatives. Those forces impact the balance sheet by 100s of billions annually. Those forces also have an upward trajectory, which means that if the Fed does nothing for a number of years, the balance sheet will be fully absorbed and have to be enlarged. We estimate that currency, required reserves, Treasury operating needs, and some smaller items already require a balance sheet nearly $2.5 trillion in size.
What was originally an emergency action has morphed into a global financial construction. For example, under present banking rules, Treasury bills and excess reserves are perfect substitutes for meeting requirements and can be used to meet the LCR (liquidity coverage ratio) test. T-bills and reserves are 100% qualified HQLA (high-quality liquid assets).
Mortgages are not 100% qualified. That is due, not to any perceived credit or default risk, but instead to a rule created when the mortgage trading market was suffering from financial-crisis-induced illiquidity.
Suppose the Fed changes the rules. Suppose it allows banks to hold federally backed mortgages with no penalties, just as would be the case if the banks held Treasury notes and bonds. That rule change by the Fed would enable it to allow some runoff of mortgages as banks stepped in while the Fed backed out.
Numerous research papers examine these types of changes and the ways in which they might be accomplished.
Let's sum this up.
First, the Fed has no intention of shocking or surprising markets.
Second, Fed personalities know the process has to be gradual.
Third, Feddies also know that shrinking the balance sheet of a central bank is fraught with risk of unintended consequences and is something that has never been tried before.
We expect a period of trial-and-error policy evolving slowly over years. We do not anticipate the Fed to sell mortgages outright for years, if ever. Runoff is more likely. And we expect minimal shocks to the US bond market. We must also note that any repatriation tax change will have a minimal impact on the Fed or its balance sheet policy. American corporations may move $1–2 trillion, which seems like a large sum. But for the world as a whole, where the five large central bank balance sheets total about $20 trillion, a few hundred billion moving around is really quite minor. Any shock from this movement could be easily sterilized among the central banks.
There are still questions about bonds and their yields and interest and inflation rates. These are mostly independent of the Fed balance sheet decision as long as the Fed follows a no-shock policy. That means there are still some bond investment opportunities.
As of last week, we still believe the 4% high-grade, well-researched, tax-free US-dollar municipal bond to be one for the cheapest securities and best bargains around. (Note: Exacting research is needed on credits so as to avoid headline risk and possible default risk.)
Last week we saw very-high-grade tax-free bonds at 4% when the taxable US Treasury bond was under 3%. That is a bargain. The Fed poses no risk to it.
Let's move to fishing. We've organized groups known as "Camp Kotok" (Google (NASDAQ:GOOGL) it for details) for many years. Readers continually ask "how can I attend?" We have a few spaces in Maine that are open right now for the last weekend in June and for Labor Day weekend. And maybe a very few at the end of August in Montana. August in Maine is filled. Email me if interested and I will connect you to Sharon Prizant to obtain details. These are first come, first served.