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In April 2017, Fed officials announced plans to significantly reduce the size of the Fed's balance sheet as early as 2017. The need for this decision was motivated as follows. The Fed's balance sheet contains securities purchased by the Fed during QE. These are mainly treasury bonds and MBS (mortgage backed securities). These securities were purchased in order to lower rates. The goal was achieved, the US economy came out of recession and now there is no point in keeping them on the balance sheet.
Also, Fed officials said that the sale of MBS and UST would lead to an increase in rates in the economy, i.e. will become another tool for tightening monetary policy, similar to raising the discount rate.
But this week the blog Econimica offered another explanation for the need to shrink the Fed's balance sheet.
See diagram. The yellow curve is the Fed's balance sheet, the blue curve is the banks' excess reserves.
As you can see, during QE, the Fed's balance sheet grew from $0.9 trillion to $4.5 trillion, and banks' excess reserves grew from $0 to $2.7 trillion. dollars. In other words, the Fed issued 3.6 trillion. dollars, but 2.7 trillion. dollars remained on the correspondent. bank accounts with the Federal Reserve. According to the mind, these are 2.7 trillion. dollars should have entered the economy in the form of loans to the company. banks were not included in non-financial organizations because there was not enough investment. projects (assets with an acceptable return-to-risk ratio). The question arises: why was it necessary to print 3.6 trillion. dollars if 2.7 trillion. dollars (75%) never entered the economy. Apparently, the size of the issue was dictated by the number of defaulted MBS on the balance sheets of banks. To improve the banks' balance sheets, these mortgage-backed securities had to be purchased from the banks at non-market prices. This is how the banking system was saved from bankruptcy.
Since 2008, the Fed has been paying banks a return on excess reserves at the IOER (interest on excess reserves) rate. The Fed sets the IOER rate in the same way as the discount rate. Now its level is 1.25%.
Now look, in 2015, excess reserves began to slowly decline. By the end of 2016, they fell by 0.8 trillion. dollars up to 1.9 trillion. dollars. Apparently, this was due to the improvement in the economy. And then the Fed began to vigorously raise the discount rate and excess reserves began to grow again. See diagram.
The beige curve is the Fed policy rate, but IOER is equal to the Fed policy rate. The diagram shows that excess reserves began to grow simultaneously with the rise in the Fed rate and, accordingly, the IOER rate. And they grew from a minimum of 200 billion dollars.
As a result, paying banks for their excess reserves has become costly for the Fed.
The black curve is the Fed's expenses in the form of payments to banks for their excess reserves. Now it is 27 billion dollars a year. There will be more to come.
At a Fed discount rate of 3%, Fed spending would be $64 billion in annual terms. It's a lot. And there is no point in paying banks such large sums. Banks are already doing well. Therefore, excess reserves need to be reduced. To achieve this, the Fed's balance sheet will be reduced.
True, it will not be possible to significantly reduce the balance. Those MBS that the Fed once bought from banks are now worth 10% of the purchase price.
Fed balance sheet reduction plan in 2018
1Q - $10 yard, 2Q - $20 yard, 3Q - $40 yard, 4Q - $50 yard.
The point is clear)) How much will the pressure on bond sales increase and profitability increase accordingly? It is also worth noting that all these increases in the budget deficit, national debt, and Trump’s spending will also put pressure on bond yields, and in September the ECB plans to reduce its QE, which also puts pressure and will put pressure on bond prices and rising yields.
And besides, the Fed plans 3! raises this year (unlikely to happen).
I believe that by the end of the first quarter it will become clear that either the growth in yields will continue to suppress the stock market, or the stock market will be blackmailed by the Fed’s declines (as has always happened), and they will adjust the program for draining the balance sheet and the number of rate increases.
Follow the statements of the Fed officials, there will be maneuvering with formulations like - “depending on the situation in the markets, due to instability in the markets, the Fed may reconsider the pace of balance sheet reduction and tightening of monetary policy” - as soon as such statements follow, bonds will jump = yields will fall = stock markets will rise.
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Educational program about QE.
What is QE?
Quantitative easing (QE)— monetary policy used by the Central Bank to stimulate the economy when traditional methods are ineffective.
- At traditional politics The Central Bank buys or sells government bonds to change interest rates. When they are close to zero, to stimulate the economy you have to either use QE or move to negative rates.
- At quantitative easing The Central Bank purchases assets (such as bonds) from financial institutions to increase the money supply without affecting the rate.
Why is this necessary?
The theoretical effect of QE: the Central Bank buys the assets of banks, and they use the money received to expand lending at reduced rates. This leads to an increase in activity: people who previously did not have access to loans due to high rates begin to take out loans and pour them into the economy.
In the US, quantitative easing was introduced to achieve a number of goals. Among them:
- Job creation. The Fed argued that the extra money from QE would allow business owners to hire more employees.
- Stimulating lending. By purchasing Treasury bonds, the Fed lowered long-term lending rates. This was necessary for economic growth.
- Consumption growth. More money in the economy could stimulate consumption. This should have led to increased profitability of companies, growth of the stock market and, ultimately, economic recovery.
- Support for low rates. In the late 2000s, the federal rate hovered between 0% and 0.25%. The Fed could not continue lowering rates - it needed another way to stimulate the economy
How much has the Fed's balance sheet reached?
In the United States, the quantitative easing policy was carried out in three stages: in 2008, 2010-2011 and 2012-2014.
Janet Yellen announced the end of the asset purchase program on October 29, 2014. At that time, the Fed's balance sheet reached $4.48 trillion. Due to reinvestment of bond payments, it has remained at approximately this level for almost two years.
Below Fed Balance Sheet History:
The bulk of the balance sheet consists of Treasuries ($2.5 trillion) and mortgage-backed securities ($1.8 trillion), according to official filings.
Reduction of assets.
Causes.
Among the reasons for reducing the balance are the following:
- A large stock of assets in the hands of the regulator creates a distorted picture of the market for investors. As a result, they take too many risks.
- Buying a large number of mortgage bonds leads to excessive stimulation of the real estate market. At the same time, other sectors do not receive proper funding.
- The size of the Fed's balance sheet is criticized by Republicans: according to them, it makes it possible to service a large budget deficit. Reducing assets may ease disagreements.
Institute of International Finance: An estimated $200 billion cut in the Fed's balance sheet for emerging markets would be equivalent to three 0.25% interest rate hikes.
Trader RBC Capital Markets Brad Scott believes the new policy will be a plus for some: “The result will be an increase in bank profits. There will be more opportunities [for Wall Street] with increased volatility. New entrants are also likely to enter the market.”
Greg MyBride, Chief Financial Analyst at Bankrate.com, expects the process could take 15 or even 20 years, during which the Fed will take “breaks” from shrinking its balance sheet, or even return to expanding it, during crises: "The Fed will not be able to sustain aggressive balance sheet contraction. The economy will inevitably experience a slowdown long before the balance sheet is significantly reduced." In its history, the Fed has already tried to reduce its balance sheet six times: in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000. On five occasions after this, the country's economy went into recession.
"Initial effect. Initially, the excess reserves of those from whom the Fed bought assets - primary dealers - will be reduced. These are large American banks - such as Goldman Sachs, JPMorgan - and their foreign competitors.
The main blow. Primary dealers, in turn, will reduce their purchases of securities of companies and smaller banks. For the latter, the blow will be much stronger: if large banks have excess reserves, then for small banks, selling their securities may become a matter of survival. Most likely, they will want to play it safe and issue issues before the QE phase-out begins. As a result, up to this point their stability may even increase briefly.
Financial markets. Even before the Fed stops buying assets, first of all, “junk” bonds will be thrown into the market. Next, the trend will spread to higher tranches of bonds, Treasuries and stocks.
Dollar. Usually, when banks have problems, the dollar strengthens - debt buyers need it. However, the sale of Treasuries will most likely cause distrust in this currency, against which it will begin to fall. Accordingly, inflation will increase.
Goods. Due to inflation and problems in the stock market, physical assets may attract the attention of investors: first of all, gold and oil. The latter, however, is unlikely to start growing - most likely, growth will simply stop.
Russia. The problems of the United States will naturally spread to the rest of the world, including Russia. Initially, the ruble will begin to fall. However, if banks begin to signal negative effects and the supply of money decreases, then the dynamics of the Russian currency will decrease in the opposite direction. In this case, the situation will depend on the actions of the Central Bank: whether the regulator will increase the money supply or allow the ruble to strengthen.
Further policy of the Fed. There is a relationship between a reduction in the balance sheet and an increase in the rate - both measures are elements of a contractionary policy. It is difficult to give quantitative estimates, since the connection between them is indirect. However, for now, statements by Fed representatives signal that the regulator is unlikely to abandon its plans to change the rate."
GKO maturity dates occur in the middle and end of the month. And these securities disappear from the Fed’s balance sheet at the middle and end of each month. The Fed does not sell Treasuries. Waits for the maturity date and disposes of the dollars by pressing the "delete" button. Which is typical. It is the Fed that bears the burden of purchasing the American government’s short-term debt.
We are talking about the securities that the Fed bought for balance during the crisis of 08-09 and only Treasuries (there are 50-55% garbage that apparently will remain on the balance sheet forever)
The Fed is selling securities, because there is no point in recycling, what they will definitely buy from you (debt - Treasuries is not mortgage garbage, which no one needs and should be liquidated by pressing the "delete" button and not T-bills that can be sold) However, growth yields indicate that they are starting to experience inflation (as the economy accelerates) 4.2% of GDP for 2Q18 was (latest data) and due to the fact that the Fed was reducing its balance sheet by 40 billion per month, it was and now and there will be 50 billion each, it may not be possible to immediately find buyers for GKOs (and the yield is growing). Or those who are obliged to buy immediately after the purchase drain it. If some kind of boiling starts (real in the world), the crowd will rush to GKOs and the yield will sharply win back reduced to maximum as it was after Lehman, everyone rushed to treasuries. (and profitability fell sharply)
Regarding the timing, the middle and end of the month, the Fed, as far as I know, does not show (day to day) or, as far as I know, with a delay it may show the movement of funds, or certain operations. (after the fact and/or after a couple of weeks, show what happened yesterday only at the end of the month)
For short-term up to 1 and 2 years(I can’t say anything here) I haven’t been following them and perhaps the Fed bears the main burden of purchasing ( I'll find out if I ask anyone )
By the way, I’ll definitely write more about what and how.
Now, further, regarding oil, after OPEC + Russia reduced and cut (there was about 1 - 1.5 mil bar per day. There was a surplus of oil on the market, which put pressure on prices), the price went up and in oil exporting countries, it became easier (but other developing countries who don’t have worse oil)...
Here’s what, gradually, after a 16-year cut (in production), oil prices began to rise, inflation began and the markets of developing countries, primarily (oil exporters), began to revive; their purchasing power of GDP began to grow and, little by little, the income of the population, which, in general, increased consumption and increased demand for oil; along with the growth of the world economy (and it is still growing), the price of oil is also rising. At the moment, it is growing along with the growth of the dollar, which indicates a deficit (which is still wasted- and presumably saving yes, Although maybe we already in equilibrium) reserves are growing for 2 weeks in a row - this is the only indirect factor available to us by which we can find out/assume with a high degree of probability in the absence of real (which comes with a delay) data there is a Deficit, equilibrium or Surplus in the physical oil market.
The simple fact is that US oil inventories have dropped by almost 150 mil bar. during this time, talks about d shortage of oil, and therefore increased demand, as a result of the growth of the global economy.
Also regarding Treasuries, many people need liquidity (many have debts in dollars) by dumping Treasuries, they go to the cash and pay off the debt. (partially the dollar index for trading partners speaks about this; when oil was at the bottom, it is almost at the top)
Regarding Turkey, Pakistan, Argentina (they built the same pyramid of state bonds as the Russian Federation at the time of default in 1998) are now paying the price, India, Pakistan, Central Asia, etc., it is precisely the sharp increase in borrowing that is responsible for the growth of these countries before the crisis, high GDP growth rates (they they have no oil and fuel inflation), hit them harder when prices and the value of the dollar began to rise, a logical chain:
their debts, - increase in interest rates on payments, +/ increase in fuel prices, - capital outflow, - sales to the markets of their state bonds, - devaluation of the lira, - increase in the rate of their Central Bank, - shrinkage of economic activity with rising rates as in Turkey before 27% seems to be - who/how many? will people take out loans for which business at such and such percentages? - a collapse in the markets and a crisis and a self-twisting loop.... They were the first to go into the crisis; they are the harbingers, as in 1997-98, who was the first to collapse
I'm here outside the auditorium I’m still observing, and so it may be a harbinger of what the world experienced in 1997-98, the Asian crisis and then covered the rest. (he behaves very similar)
And oil seems to be peaking, somewhere on the way, this is the reason when rising demand pushes prices up, despite the fact that the dollar is also growing. It was the OPEC + Russian agreement that made it possible to increase the price of oil. As soon as (IMHO) American reserves are transferred for 400-420 million(most likely this is a signal) that there is no longer a shortage in the physical oil market (Saudi Arabia and the Russian Federation are trying...) and there is a surplus again (due to contraction in demand in many developing countries, n e oil exporters) they suffer doubly, they have fuel inflation and do not have their own oil. (Turkey, Egypt, India, Pakistan, Argentina, etc.) and prices will begin to decline or adjust before a new high (depending on how the stocks are filled/emptied) the price will rise down = excess, they will decrease, or even stand at place approximately, rather an increase in prices, or at the same level.
And I don’t argue that oil is a key commodity; it is by monitoring it and the peak of oil that we will know when the crisis will begin. But I’ll say right away that most likely there will be either a seesaw (increased production/cut, increased again if they could/cut again) an attempt to maintain the balance of the price swing. Oil has become very expensive, with such a dollar... And an example:
https://tmsnrt.rs/2OzVObC- oil in euros
https://tmsnrt.rs/2OzVRUQ- oil in yen
https://tmsnrt.rs/2OG5HEy- oil in rupees
It’s a pity there was no oil in pounds, but it is in pounds that oil is the most expensive for Britain, because... when 2.1 dollars = 1 pound a barrel of oil was for Britain (for the English consumer) in 2008, when oil was 120 dollars a barrel + / and 2.1 pound it cost 59 - 60 pounds. Now oil in dollars is 85 dollars a barrel, and in today's pounds it is approximately 65. those. 10% More expensive oil for consumers in Britain now than when it was $120 in 2008 .
Fuel inflation in the world with the growth of the dollar is also (I think there is something EPROY and a peak) But here you have to think... look for logical chains
And once again I’ll find out about debts BEFORE 2 years (what I described with 5-10 years) + we must remember that in addition to buying back the debt, the Fed also exchanged short-term securities for longer ones. (I'm talking about the period 08-09 reduction - sale of balance)
Presented a scheme for reducing the balance The whole question is when the regulator will act and how much it will reduce the balance. Restrictions, apparently, will be in force until mid-2020
During the financial crisis, the US Federal Reserve accumulated approximately $4.5 trillion in various assets on its balance sheet, and the time has come to reduce it.
In fact, they should have gotten rid of these assets a long time ago, but the regulator does not want to part with treasuries and other securities.
As a result, the Fed decided to cut almost ten years after the start of the financial crisis.
The basic idea is that the Fed will stop reinvesting in Treasuries once they mature.
Gradually, this “slowdown” in reinvestment will intensify. If at the beginning the Fed invests monthly in the market only amounts exceeding receipts of $6 billion from Treasuries and $4 billion from other assets (mortgage securities), then this “ceiling” will increase by the same $10 billion ($6 billion for bonds and $4 billion in mortgage-backed securities) each quarter for a year until it reaches $50 billion per month ($30 billion in Treasuries and $20 billion in agency securities).
The Fed said its balance sheet would end up "notably smaller than in recent years but larger than before the financial crisis" as banks demand higher reserves from the Fed. And this is a rather vague goal, considering that before the crisis, the Fed's balance sheet was only about $800 billion.
The Fed believes that under this approach, "retail investors will have to absorb the balance as we have reduced our inventories, and the cap should protect against negative movements in interest rates and other potential market fluctuations."
“I cannot tell you what the longer-term normal level of reserve balances will be, because this will depend on the committee's possible decisions regarding effective monetary policy over the long term, as well as unknown factors, including the future demand of banking systems for reserves, and as well as various other factors that could affect reserves," Fed Chair Janet Yellen said.
This level of detail in the Fed's plans is the main surprise. At the same time, the biggest question now is regarding how soon the balance sheet reduction will be implemented. Analysts say the best chance is for it to start in September or December. Under this approach, the Fed would reach its maximum ceiling by the end of 2018, and then would have to maintain restrictions until about mid-2020.
Yield curve
It is worth noting that the US Treasury yield curve is becoming flatter.The problem is that the Fed will need to issue more long-term securities anyway. Now there are too few of them in free circulation. The Fed owns 35% of Treasuries with maturities of 10 years or longer.
And for securities with a maturity of more than 1 year and in combination with foreign buyers (especially central banks), this figure is about 65%. That is, two-thirds of the total volume of US long-term securities is held by persons who are generally insensitive to market forces.
That is, the bond market is now highly distorted and cannot be viewed as a reliable reflection of economic fundamentals. But many still pay attention to this, determining the health of the economy based on the bond market.
This can lead to what George Soros calls "reflexivity," where a negative but false signal from the bond market actually causes an economic downturn or leads to a recession.
Therefore, the Federal Reserve will sell more long-term securities to steepen the yield curve.
If the Fed simply shifts redemption funds into similar securities in the coming years, this will cause additional pressure on short-term interest rates, even as the key rate rises. It could also potentially lead to an inversion of the yield curve and destabilize money markets.
In 2018-2019, for example, large volumes will be repaid, and if funds are invested in longer-term securities, this will smooth out negative trends in the market and become a more optimal strategy for reducing the Fed’s balance sheet.
However, the total stock of Treasury securities with maturities greater than 10 years is less than the total market capitalization of Amazon, for example.
This gives the Fed plenty of leeway if bonds become too oversold, as it will be easy enough to get the yield curve back on track.
Recall that the Fed lost control of the yield curve before the financial crisis, driving capital flows back into the US. This is what Alan Greenspan identifies as the main cause of the housing bubble. The Fed raised funding rates by 4.25 basis points. p., while 10-year mortgage rates remained unchanged at 425 bp. p., and 10-year mortgage rates remained virtually unchanged.
The risk is that foreigners start selling. But where will they go?
In Spanish 10-year papers yielding 1.43? German bonds offering a yield of 0.266%? How about 10-year Japanese bonds yielding 0.067%? In fact, low yields on foreign securities or high risks on them are keeping 10-year rates around 2.6%, and this is another factor distorting the yield curve.