The Fed chair backtracked on the balance sheet in January, saying the Fed “wouldn’t hesitate to make a change” if the Fed concluded the balance sheet ”was part of the problem”. What would happen if the Fed stops shrinking its balance sheet?
Warning: this is an exploratory strategy piece and not necessarily consistent with Nordea’s forecasts.
In mid-December we highlighted a possible (though unlikely) tail-risk game-changer ahead of the Fed’s monetary policy decision, the game-changer being a pause or perhaps a slowdown in the balance sheet shrinking process. Alas, Fed Chair Powell didn’t listen. Instead he managed to invite even tighter financial conditions, thereby creating more near-term downside risks to US activity than was already on the cards.
Chart 1: Fed Powell created even more downside risks to US growth in December
Just a few weeks later, not only has the Fed Chair said that there is ”no preset path for policy”, that the Fed ”will be patient”. That the Fed is ”prepared to shift the stance of policy … significantly” [as in 2016 when the Fed took a one-year long pause in its hiking cycle (if needed). While the Fed’s balance sheet policy was on auto-pilot in December, now the Fed ”wouldn’t hestitate to make a change” if it concluded the balance sheet ”was part of the problem”. Other Fed officials, such as Fed Williams and Fed Kaplan have also indicated an openness to change the balance sheet policy (the automatic ”unprinting” of excess dollars up to 50bn/month).
Chart 2: EUR/USD vs US excess liquidity creation/destruction
As bonds on the Fed’s balance sheet matures the US Treasury pays back its debt (on SOMA days). The amount of bank reserves (electronic dollars) consequently shrinks, as does excess liquidity. While there is no consensus among neither macro economists nor market participants that liquidity actually matters, using the KISS principle (Keep It Simple, Stupid) one can ask oneself, if there are fewer dollars around, should it be more or less costly? Hmm!
The First Law of Economists: For every economist, there exists an equal and opposite economist.
– David Wildasin
We consider ourselves pragmatists. If something helps predict markets, then we pay attention. Last year we definitely did not buy into ex-Fed Yellen’s comment that “[the shrinking balance sheet] will be like watching paint dry”, as we though (and still think) the Fed’s liquidity pump (or absorption) does show decent correlations to many different market prices – too decent to ignore. We even speculated in a Buenos Aires accord as the Fed could have to realize that the world is more dependent on ample dollar liquidity than it thinks.
Chart 3: The IOER-EFFR spread vs US excess liquidity
One way in which the balance sheet might matter for the Fed is via its impact on the money market and on the Fed’s ability to keep the Effective Fed Funds rate (EFFR) within its target interval. Theoretically, assuming no frictions, as long as there’s one more dollar in the system than required, excess liquidity shouldn’t matter at all, but as excess liquidity has dwindled, the EFFR has been pressured upwards. This is why the Fed has twice needed to hike the IOER rate by 20bp instead of the usual 25bp. The Fed has (so far) blamed T-bill issuance for this effect. But, excess liquidity trends predicted it…
In the latest published primary dealer survey, the reduction in the supply of reserves in the banking system (roughly excess liquidity) was believed to become a very important factor influencing the IOER-EFF spread (…) over the last three quarters of next year . So while the relationship in chart 3 might just be a coincidence, things are expected to change in just a few months. “The last three quarters” of 2019 is after all less than 90 days away.
Chart 4: More US macro weakness on the cards
While ISM manufacturing plunged already in December, we foresee further US macro weakness in the wake of dollar strength and the 2016-2018 repricing of rates (Nordea View). The trend convergence between US ISM and EMU PMI has begun, we believe. One can also never rule out a growth disappointment in the first quarter, as such have seemed surprisingly common in recent years.Also, what if the Fed has not changed reaction function hawkishly under Powell after all? (Reminiscent of BIS Borio, the Fed Chair has been talking much more about financial stability than Yellen ever did. This possible shift suggests Powell may turn hawkish quickly if risk sentiment improves)..
Chart 5: US small caps vs US excess liquidity momentum
This gets us back to our balance sheet speculation. What if weak macro, tighter financial conditions and growing problems in steering the effective Fed Funds rate together brings about an early pause in the shrinking of the Fed’s balance sheet (stopping Quantitative Tightening)?
We provide two different excess liquidity scenarios in the attached chart book. In the main scenario: i) the US Treasury cash’s cash cushion declines below 200bn in early March owing to effects relating to the debt ceiling (this boosts excess liquidity), ii) the public’s cash usage rises in line with recent trends (negative for excess liquidity) and iii) the Fed B/S shrinks in line with Fed’s announced strategy (very negative for excess liquidity). In the alternative no QT scenario, the Fed instead stops shrinking the balance sheet altogether already on April 1.
In a no QT scenario, the peak of the dollar may be behind us, it may be time to pick up EM FX, the US 10y yield could start to climb, risk appetite could with a vengeance (tighter credit spreads, outperforming small caps), and more… – Much in line with how markets have behaved since Powell’s Friday speech.
For sure, this is a univariate analysis, and the global macro situation probably needs to deteriorate further (but by how much?) before the Fed (and others) react, but, consider this some risk-positive food for thought.
For many more charts, click for the full PDF here.