In brief

• The scale and timing of monetary stimulus from the Federal Reserve (the Fed) in recent weeks has dwarfed its response during the Global Financial Crisis.

• The terminal size of the Fed’s balance sheet depends on the shape of the recovery. Under a sluggish growth scenario, the balance sheet could exceed 10 trillion USD in size. A quicker recovery may limit its size to just 8 trillion USD.

• A world flushed with liquidity suggests investors will need to get accustomed to a low-yielding environment. However, potentially higher inflation poses a risk to that outlook.

Since the beginning of March, the Fed’s balance sheet has expanded by 2.9 trillion¹ USD, meaning that in eleven weeks, the balance sheet has increased more than it did over the five-year period post the Global Financial Crisis (GFC). There are two primary drivers of this unprecedented increase: the restarting of the asset purchase program and the roll-out of several funding and corporate credit facilities. But how big could the balance sheet get? In this paper, we estimate the terminal size of the balance sheet under different ‘letter-shaped’ recovery paths: ‘V’, ‘U’, ‘L’ and ‘W’.

To frame the balance sheet discussion, we consider the impact to real GDP, employment and inflation under each recovery scenario given their developments over the next 18 months will likely drive any further adjustments to monetary policy (appendix). Our base case is for a ‘U’-shaped recovery where the economy collapses in the second quarter, stalls until the successful distribution of a vaccine and recovers strongly thereafter. However, given the level of uncertainty regarding this outlook, several outcomes should be considered.

To infinity (asset purchases) …

In restarting its asset purchase program, the Fed has uncapped the amount of U.S. Treasuries and agency mortgage-backed securities (MBS) it can purchase, a stark pivot from targeted purchases observed in previous rounds of quantitative easing (QE). Therefore, the shape of the recovery and its impact on broader financial conditions, will dictate asset purchases going forward.

While the initial buying wave was enormous in scale, more recent activity can provide some near-term forward guidance. Recent purchases have been focused on improving Treasury market functioning and to its credit, conditions have improved. As shown in Table 1, after a massive 5-week buying spree beginning in mid-March, the current pace of Treasury purchases has slowed dramatically from a peak of close to 75bn USD/day down to roughly 5bn USD/day. Similarly, gross purchases of agency MBS have slowed to a pace of roughly 4.5bn USD/day. We expect this pace to continue through June as the shape of the recovery becomes a bit clearer.

Moreover, and perhaps unsurprisingly, under each scenario, the bond portion of the balance sheet expands significantly, particularly if the recovery is more drawn out than anticipated.

Source: FRBNY, FactSet, J.P. Morgan Asset Management. Quarterly figures shown are the estimated average monthly pace of net purchases of U.S. treasuries and Agency MBS in a given quarter. *Current level is as of May 22, 2020 and is reported on the Federal Reserve's H.4.1. table. **Current pace is based on average daily purchases through the week ending May 22, 2020 and is the pace expected to last through June 30, 2020. ***Reflects 5-week cumulative purchases from March 13 - April 17 when activity was at its peak. MBS paydowns are assumed to be 40bn USD/month through 2021. L-recovery assumes agency MBS holdings reach 2.6 trillion USD accounting for roughly 40% of agency MBS market, at which point we assume a stable agency MBS level and additional purchases directed to U.S. treasuries. Fed purchases of agency CMBS have been minimal and do not meaningfully impact these assumptions. Data are as of May 27, 2020.

In theory, what goes up can always come down, however, the Fed’s ability to shrink its balance sheet is questionable. In October 2017, the Fed attempted to reduce the size of its balance sheet, but a dramatic tightening in financial conditions ensued and the Fed was forced to halt only nine months later. Therefore, a bloated balance sheet is likely to be a permanent feature post-pandemic.

…and beyond (lending facilities)

Elsewhere, the introduction of broad-based lending facilities has taken the Fed into unfamiliar territory. With the support of the Treasury, the Fed now has 2.9trn² USD in total lending capacity being made available across eleven facilities, three of which were brought back from the GFC³. Many of these facilities are due to expire at the end of September 2020, however, an extension may occur if the recovery is slower than hoped.

It is important to note that while these facilities are available, it is unclear how much lending will be conducted, making forecasting this part of the balance sheet particularly challenging. Still, we make three broad assumptions: first, the hoarding of cash by businesses and consumers is largely behind us; second, large companies have a number of financing options including revolving lines of credit, robust demand for debt issuance in the primary markets and, in some cases, direct fiscal support (airlines, hospitals, etc.); and third, smaller-sized businesses are likely to lean on Fed facilities more given fewer financing options and less of a cash cushion than their larger-sized counterparts, though complex eligibility requirements may pose a challenge. Furthermore, revenue challenges across state and local governments suggests robust participation as well (MLF).

Given this, we expect low participation within the short-term funding facilities (CPFF, PDCF and MMLF) of 10-20%; moderate participation within the big business facilities (PMCCF, SMCFF) of 30-40%; and fairly robust participation within the direct small- to mid-size business and municipal lending facilities (MSPLF, MSNLF, MSELF, MLF) of 60-70% of respective lending capacity. In addition, we consider adjustments under various recoveries, details of which can be found in the appendix. All things considered; the Fed’s loan portfolio could expand by an estimated 1-3 trillion USD.

Balance sheet considerations

Exhibit 1 highlights the overall expected growth of the balance sheet under different recovery paths. Even in the most optimistic outcome, the balance sheet doubles in size to north of 8 trillion USD, with the most adverse economic scenario pushing the balance sheet to 14 trillion USD.

Exhibit 1: Fed balance sheet forecast under different recovery scenarios
USD trillions

Source: FactSet, Federal Reserve, J.P. Morgan Asset Management. Balance sheet level and forecast excludes T-bills. Agency MBS includes agency CMBS. Other includes other assets like gold, foreign currency and repo activity which are held steady through the forecast period. Data are as of May 27, 2020.

Not only will the size of the Fed’s balance sheet increase drastically, but its composition will likely be different. As highlighted, the Fed is offering a considerable amount of lending capacity to markets, which will result in a significantly higher loan portfolio as a percent of the overall balance sheet. This portion could take years to reduce at no direction from the Fed given the 4- to 5-year loans being offered across the credit facilities.

Moreover, based on its current buying trajectory, the Fed could own close to 40% of the agency mortgage market by the middle 2021, a similar level following its third round of QE in 2012. While we do not view this as a constraint for the Fed, we do expect it may begin to transition to a Treasury-only purchase scheme.

Investment implications

• The balance sheet is set to expand significantly. Our base case of a ‘U’-shaped recovery could cause the balance sheet to reach close to 10trn USD by the end of 2021, and potentially even higher under more adverse economic scenarios.

• A rising balance sheet may prompt worries of runaway inflation however, structural features within the economy such as banking regulation, aging demographic profiles and a cautious mindset amongst economic agents are likely to keep a lid on overall pricing pressure⁴. Still, there is potential for higher inflation given the sizeable increase in the money supply. Therefore, investors should be positioned for modestly higher inflation as the economy recovers suggesting exposure to sectors like Treasury Inflation-protected securities (TIPS) and floating-rate notes (FRN).

• The scale of asset purchases and subsequent Fed ownership of the Treasury and agency mortgage market suggests potentially more stable volatility conditions within these sectors, yet at more depressed yield levels. This also implies greater exposure to high-quality credit and municipal debt, alternative assets like real estate and infrastructure and hybrid securities like convertible bonds and preferred stock in order to bridge the income gap.

• Still, core fixed income should continue to serve as a portfolio ballast and useful hedge against equity market volatility, meaning government bonds should continue to be a core part of the portfolio.

¹ Change in total asset size of the balance sheet between Feb. 28, 2020 and May 22, 2020.
² Excludes term repo operations.
³ A detailed list of 13(3) Facilities announced during COVID-19 Pandemic can be found on here on the FRBNY’s blog.
⁴ We discuss this topic in further detail in the OTMI post:  Will the Fed cause inflation? 

Appendix

Economic assumptions under various recovery scenarios

• V-shape: Economy recovers sharply following a steep decline in the second quarter. Precautionary health measures help contain the spread of the virus while economy successfully reopens; labor markets improve quickly and unleashed pent-up demand allows the economy to recover strongly into 2021.
• U-shape: Social distancing plunges the economy into recession in the second quarter while heavy government aid prevents a significant further slide. Despite this, a lack of testing still leads to significant mortality into 2021, with the economy struggling to recover until the distribution of a vaccine. At that point, the economy comes back strongly with potentially modestly higher inflation and long-term interest rates in 2H21.

• L-shape: Reopening of the U.S. economy is largely unsuccessful as the fatality toll remains elevated. Businesses struggle to reopen, and unemployment remains elevated. Medical science is unsuccessful in coming up with a vaccine or antiviral. Inflation remains subdued amidst weak demand and the Federal Reserve and U.S. government continue to remain accommodative through asset purchases and ballooning deficits well into 2022.

• W-shape: Partial reopening allows the economy to recover, but the combination of a lack of adhering to safety measures and varying reopening plans across states, leads to a second wave of infections causing the economy to shut back down again in the fourth quarter. Thereafter, the economy slowly recovers again until the successful distribution of the vaccine allows for a still robust, yet more stable recovery into the 2H21.

Source: J.P. Morgan Asset Management. Dotted red box indicates base case estimate. 'U' shaped real GDP and unemployment estimates are based on JPMAM estimates using historical regression analysis. 'V' shaped real GDP and unemployment estimates are based on J.P. Morgan Economic Research as of May 15, 2020 and assume a sharp rebound in economic activity. 'L' shaped real GDP assume 50% of the 'U' recovery in 3Q20 and 4Q20 before settling at 0.5% q/q saar pace through 2021. 'L' shape unemployment assumes 50% of the 'U' unemployment recovery through 2020 and average annual unemployment declines of 1% in 2021. 'W' shaped real GDP and unemployment assume a 'V' recovery in 3Q20, 50% of the expected contraction in 2Q20 occurring in 4Q20 and a resumption of 'V' recovery beginning in 1Q21. Estimates are as of May 27, 2020.

Loan portfolio assumptions under various recovery scenarios

• V-shape: Facilities remain in place as anticipated through September 30, 2020. Funding facilities see little ongoing activity and no increase in lending capacity is required.

• U-shape: Facilities are extended at least until December 31, 2020 and the Fed to request an additional 100bn USD in equity support (close to 50% of current committed Treasury capital) distributed proportionately across the facilities. Participation rate remains constant.

• L-shape: The Fed plays all its cards, requesting the full estimated additional Treasury capital of 250bn USD, equating an additional 2.5 trillion USD in lending capacity, and extending facilities through 2021.

• W-shape: Same assumptions made under a U-shaped recovery, with greater participation in funding and corporate facilities. Facilities are expected to remain up and running through June 30, 2021.

Source: Federal Reserve, FactSet, J.P. Morgan Asset Management. Figures are rounded. Data are as of May 27, 2020.

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