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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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Doesn't sound like a hot story, but it's getting there .... the Fed, its balance sheet, and what to do with it. ref :- "Federal Reserve Ponders How to Do The Big Unwind : Quick Q&A" Bloomberg 14/3

March 20, 2017

 

Doesn't sound like a hot story, but it's getting there .... the Fed, its balance sheet, and what to do with it.

 

ref :-  "Federal Reserve Ponders How to Do The Big Unwind : Quick Q&A" Bloomberg 14/3

 

It's not as though we haven't discussed the subject, but the issue of how and when the US central bank is going to set about reducing its swollen balance sheet is becoming the focus of more and more attention. Since the process would effectively represent a form of monetary tightening, investors want to know how it will play alongside the more obvious tightening measure  --  that of raising short-term interest rates. Last week Bloomberg put out a useful little Q&A guide to the topic, and since reducing the balance sheet is likely to become a crucial element of Fed policy, we thought it worthwhile to refer back it.

 

First, some background ..... After the financial crisis, some dramatic measures were required to boost a US economy flirting with disaster. To that end, the Federal Reserve embarked on a policy of buying huge amounts of government bonds and mortgage-backed securities in order to keep long-term borrowing rates low and thus boost growth. The process was of course called Quantitative Easing (QE), and having to hold these newly-purchased assets on its books obviously expanded the size of the Fed's balance sheet.

 

After three rounds of QE (the last finished in October 2014), that balance sheet was swollen to $4.5 trillion  --  a previously unimaginable number. Since that time, the Fed has refrained from reducing the balance sheet until such time as the economy was strong enough to absorb its tightening effects. As bonds matured, instead of just letting them fall off their books the Fed have automatically reinvested the repaid capital, thus maintaining the size of the balance sheet. But now that rates are on the way up and the economy's strong, the time is fast approaching when it will have to be addressed. The problem is, if the market's reaction to then Fed Chairman Ben Bernanke's 2013 hint that they might begin to run down Fed purchases  --  the "Taper Tantrum"  --  is anything to go by, it could all get "messy".

 

So, Bloomberg's Q&A :

 

1. What's the big deal ?

 

$4.5 trillion dollars equates to about 1/4 of the US' annual GDP. QE suppressed yields on Treasuries and mortgaged-backed debt, making it cheaper for the government, corporates and homeowners to borrow. It also reduced costs for companies in China and other emerging markets. For financial markets, lower yields mean higher prices and the expensive level of Treasuries pushed investors into equities. You could say that the Fed is inadvertently responsible for the huge rise in equity prices since 2009.

 

2. What could go wrong ?

 

Well, quite simply this has never been done before. Reducing the size of the balance sheet is another form of monetary tightening and some analysts have it that it could have even more of an effect on economies (not just in the US) than a hike in short-term rates. The fear is that the Fed will be removing an important prop for both the economy and markets. Going back to the Taper Tantrum, the resulting rise in long-term rates hit the US housing industry and emerging markets hard.

 

3. When will the unwinding begin ?

 

Who knows ? Discussions are well under way at the Fed but Chair Janet Yellen has said that there must be confidence that the economy is strong enough to withstand the withdrawal of the assistance provided by QE. She's also said that rates should be further from zero (i.e. more normalized) before action is taken. It has generally been believed that particular target was 2%, and Bernanke believes that the requirements won't be met until early next year, which would tally. But Philadelphia Fed president Patrick Harker is on record as saying the process should be considered once the benchmark rate hits 1%. As of last week, the current band for Fed Funds is 0.75 - 1.00 %

 

4. If it's so risky, why is the Fed even considering it ?

 

There is concern at the Fed and elsewhere that the Fed's huge bond holdings distort financial markets and encourage investors to take on more risk than is wise. There is also a suspicion that the heavy take-up of mortgaged-backed securities unfairly favours the housing industry over others. And then there's the political element  --  isn't there always ? Republicans have been critical of QE as it has made it easier (in this case for former President Obama) to have run up large budget deficits. If it's arguable how desperate the Fed is to deflect some of that criticism now that the Trump administration is in power, we can assume they will be desperate to maintain the Fed's political independence.

 

5. Can the Fed minimise the fall-out ?

 

Well, it will surely signal its intention well in advance of any action to give investors time to adjust. It probably won't sell any mortgaged-backed securities in order to protect the housing market. Most importantly, it won't initially sell its bond holding back into the market  --  rather, it will just allow them to roll off as they mature, and pocket the capital repayments instead of reinvesting them.

 

6. How long will all this take ?

 

Impossible to tell ..... Ben Bernanke has suggested five to seven years, just to further limit the effects. The trouble with that is about one third of the Fed-owned Treasuries (about $785 billion) mature in 2018 and 2019. And of course any strategy could change if the Fed chairmanship changes. Janet Yellen's term expires in Feb 2018, and at this stage it seems pretty unlikely that President  Trump, no fan of Ms Yellen, will ask her to stay on.

 

7. What's in the Fed's portfolio, anyway ?

 

$2.5 trillion in US Treasury securities  --  that's about 15% of all government debt held by the public.

$1.7 trillion in mortgaged-back securities  --  over 25% of that market

The balance of the $4.5 trillion portfolio is held in such assets as swaps with other central banks and overnight loans of securities and foreign currencies.

 

There you are, then ...... the nature of the problem is pretty clear, even if the solution isn't

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