Fed Balance Sheet Expansion Could Disappoint

Based on continued market normalization and unchanged Fed policies, reserves are headed towards $4.3tn at end-2020. This could clog banks’ balance sheets and limit their ability to lend. At the same time, the Fed is shifting its focus to the provision of credit to the nonfinancial sector and away from Large Scale Asset Purchases (LSAPs). As a result, Fed balance sheet growth this year could disappoint, which would be negative for gold and duration, positive for the USD, but need not be negative for credit and equities.

Very High Reserves Are Headed Even Higher

As of 10 June, reserves were $3.2tn, $1.4tn higher than at end-February and above the previous peak of $2.8tn (Chart 1). On current trends, reserves could increase to $4.3tn by end-year for the following reasons:

• The largest source of upside risk to reserves over the remainder of the year is the Treasury General Account (TGA), that has increased to $1.5bn, $700 bn above the end of Q3 balance included in the 4 May Sources and Uses table.
• At the same time, market normalization will bring a decline in some of the Fed assets. If foreign central banks followed a trajectory similar to that of the GFC they could fall to about $50bn by end 2020, against $450bn currently. Other assets likely to self-liquidate as a result of continued market normalization are Repos as well as the COVID-19-related financial sector funding facilities, namely Primary Dealer Credit Facility (PDCF), Money Market Fund Liquidity Facility (MMLF), Paycheck Protection Program Lending Facility (PPPLF), and Term Asset Backed Securities Loan Facility (TALF).
• By contrast, credit provision to the nonfinancial sector is set to increase. It consists of Commercial Paper Funding Facility (CPFF), Corporate Credit Facilities (CCF), Main Street Facilities (MSF), and Municipal Lending Facility (MLLF). These are likely to expand in H2, even in a V-shaped recovery, as even under this scenario it could take about 2 years for the economy to go back to full employment.
• On current plans the Fed is also intending to increase its securities holdings. At the 10 June meeting Chair Powell stated that ‘we will increase our holdings of Treasury and agency mortgage-backed securities over coming months at least at the current pace.’ If I interpret this as the purchases in the month to 10 June, it would represent about $150bn per month.

Reserves at  $4.3tn by end-2020 seem a lot if markets are headed back to normal functioning: in October 2019, the Fed stated that it would ‘maintain over time ample reserve balances at or above the level that prevailed in early September 2019’ or about $1.5tn.

Fed Balance Sheet Growth Could Disappoint

The Fed likely wants to avoid holding such a large amount of reserves, though probably not out of concerns over goods price or asset price inflation. Rather, the Fed’s bigger concerns in my view could be the impact of very large reserves on bank lending.  QE led to banks substituting cash to loans on their balance sheet, due mainly to the following: lack of demand for credit; inefficient regulations that discouraged risk taking; IOER that made holding reserves more attractive than lending on a risk/return/regulatory hassles basis. This time around too the expansion in reserves could crowd out lending especially as the current regulatory relief is temporary.   Basel III remains fully in place.

The Fed could slow reserves growth as its operational framework seems to be shifting, with greater focus on credit and less focus on LSAPs.  This implies slower reserves and balance sheet growth. As stressed by, for example, Clarida, most of the impact of the Fed credit facilities has been through an announcement effect rather than actual Fed purchases. March-April 2020 US corporate issuance has been the highest ever for these 2 months. In addition, because credit to the nonfinancial sector is a much more direct and powerful channel of transmission of monetary easing than LSAPs, slower security purchases may not be offset 1:1 by growth in the Fed credit portfolio.

The Fed is unlikely to broadcast this change of framework until economy and markets are on a stronger footing. Meanwhile, it could be ‘testing the waters’. For instance, Chair Powell’s vague purchase plan of ‘at least at the current pace over coming months’ gives the Fed room to experiment with a different pace of Treasuries purchases and observe market reaction. In addition, in the 2 weeks to 10 June, reserves have declined by $127bn as the Fed has not fully offset the increase in the TGA with Treasury purchases, which could be the beginning of a trend, especially if credit markets remain resilient.

If my expectations are correct, Fed balance sheet growth this year could disappoint, which would be negative for gold and duration, positive for the USD, but need not be negative for credit and equities.