The size of the U.S. Federal Reserve’s (Fed) balance sheet has started to shrink in recent weeks. Its balance sheet has declined 2.9%, or USD 210billion (bn), from its peak of USD 7.17trillion (tn) in June. Some investors are worried that the Fed is now intentionally dialing back its liquidity support and what the implication of this may be for markets. Some are drawing the comparison between this balance sheet reduction to 2013’s ‘taper tantrum’ or 2017’s short-lived ‘normalization’ process. However, the Fed’s reaction function remains the same and the reasons for the decline in the balance sheet are largely technical rather than reflective of a shift in policy.
Since the COVID-19 pandemic gripped the U.S. in March, the Fed has increased its balance sheet by USD 2.7tn. The nature of the shock and lessons learnt from the global financial crisis saw the Fed enact a multitude of other policy initiatives that all added to its balance sheet. This included several funding and corporate credit facilities, extended repurchase agreement operations (repo) and dollar swap lines to the central banks of 14 other countries.
Many of these were designed to provide short term liquidity to the market and prevent a liquidity crisis that could lead to a seizure of financial markets in the U.S. Even with the uncertainties surrounding economic recovery in the U.S., the dislocations in the fixed income markets have reduced and the overall stability and functioning improved. This reduces the need for the Fed’s intervention.
This is most notable in the repo market. The Fed’s intervention in the repo market was undertaken to maintain an adequate level of overall reserves in the financial system ensuring a smooth functioning and preventing short-term borrowing costs from spiking. As markets have stabilized, bank liquidity may now be sourced through other means (e.g. other financial institutions).
The relaxing of viral containment measures and improving economic data off of the second quarter low may create the perception that the Fed can ease back on purchases. However, the Fed’s reaction function is well understood by the market and should economic activity significantly deteriorate, the Fed will once again step in to stabilize markets. Moreover, Fed Chair Jerome Powell has acknowledged the risks around the equity market and the undesirable economic consequences should the market fall significantly. This highlights the Fed’s preference for maintaining financial stability and the strength of the Fed put in markets. Given this, the Fed will have a hard time withdrawing policy support in the foreseeable future and the Fed will remain put. In fact, the last time the Fed tried to reduce its balance sheet in 2017, financial conditions tightened to the extent that the Fed brought the ‘normalization’ process to an early end.
EXHIBIT 1: Composition of the fed's balance sheet matters as much as its size
The Fed’s balance sheet will continue to expand in the coming years as it provides support to the economy and funds the ever increasing Federal government deficit. The shift in market intervention in either repos or U.S. dollar swap lines reflects a market moving back to more normal operation rather than a policy adjustment.
Rather than focusing on the size of the balance sheet, it will be the composition that matters more, with support for the treasury and securitized market continuing as long as the Fed sees a need. The Fed’s holdings of Treasuries continue to grow, as does the size of mortgage backed securities.
Further, the temporary funding facilities, which are due to end in September, are more than likely to be extended given the either pausing in reopening, or reversal in some cases, across different states. This will interrupt what has been a sharp recovery from the trough in economic activity.
The continued backstopping of credit markets by the Fed suggests investors should continue to support the high quality segments of the fixed income market, which include investment grade and the higher rated end of the high yield market. However, it’s very clear that potential income from these assets, and core government bonds, is greatly reduced. Emerging market debt offers a higher income but on a very selective basis, while an allocation to alternative source of income, such as core real estate and infrastructure, could be considered where liquidity constraints allow.