September 14, 2016

Balancing Act

If you want to know what a business is capable of doing, look at its balance sheet.

If you want to know what the Federal Reserve is capable of doing too, look at its balance sheet. Having scrutinized it, Karen and I are leaving today to ride bikes in the Pyrenees and will return if the Fed survives.

Just kidding.  Except for the Pyrenees. We’ll report back on Catalonia in a couple weeks.

Meanwhile, there is again a glaring focus on the Fed as markets shudder. Clients know our Sentiment Index had a “four handle” at 4.9/10.0 Sept 8, the first negative read since early July. Volatility bloomed. As with weather, the market reflects preceding patterns.

It’s the same with the Fed’s balance sheet. Monday with Rick Santelli on CNBC’s Squawk on the Street I attempted to describe in a handful of seconds that the Fed can breathe in and breath out and impact rates and market stability.

Simplifying, the Fed has two levers for pushing rates up and down. When the Fed buys assets like mortgages or Treasuries from the big banks supporting our payments system (called the primary dealers), the supply of money expands, which makes credit cheaper and pushes down rates.  These are bank reserves.

On the opposite side, the Fed can borrow money from banks, tightening supply and prompting an increase in borrowing costs.  These are called Reverse Repurchase Agreements (RRPs).

We described last week how both changed little over the two decades preceding 2008. Tweaking one or the other was simple and economical. Need to tighten 2-3%? Boost RRPs by $10 billion.

But now bank reserves are $2.3 trillion, 26,000% more than historical levels. RRPs are 1000% higher than history at $300 billion. The three-to-one ratio the Fed long maintained is now one-to-26.

These facts produce a paradox that traps the Fed. Twenty-five basis points, the increase expected when or if the Fed moves, is no biggie against $10 billion of reserves.  But the Fed pays interest on reserves (and RRPs). Now 50 basis points, the rate would jump 50%.

The interest expense alone boggles the mind. Plus, the government will lose money. A rider on the December transportation-funding bill passed by Congress requires the Fed to send earnings on its massive portfolio over $10 billion to the US Treasury general fund.

Do you see? The data driving the Fed aren’t economic but financial. It’s about the Fed’s balance sheet. And government coffers, dented if the Fed starts paying more interest.

They may still hike but it’s a hindrance. And there’s more. The same giant banks providing margin accounts to traders and derivatives to institutional investors are partners called primary dealers helping implement Fed policy. When the Fed moved $100 billion to RRPs out of excess reserves Sept 1 at the same time that its balance sheet shrank slightly, the impact rippled through all the banks financing hedges and margin-trading.

That ripple is the current tsunami hitting the stock market. The Fed has already unwound these RRPs, returning $100 billion to excess reserves. But the damage was done. The Fed tried similar tactics in December last year when it hiked for the first time since 2006, and markets caved in January and the Fed had to pump up excess reserves by $500 billion – much more than it had moved out of the money supply – before markets stopped falling.

And the Fed oversteered.  Markets shot like a rocket into May, flummoxing all. Our Sentiment pegged the positive needle for weeks.

The same happened around the Brexit vote. The Fed was in the process of tightening by lowering excess reserves and lifting RRPs.  The markets imploded. In two weeks, the Fed reversed. The market shot up, once more prompting global head-scratching.

The Fed cannot seem to calibrate its levers without overshooting or undershooting and in any case creating chaos in stocks and bonds. There is no better evidence of the folly in the size of its balance sheet.

Is there a way out? Sure. The Fed could write off 80% of its balance sheet and put us back to pre-crisis leverage.  But interest rates would explode and the entire globe would fall into depression because that would be a restructuring, a technical default.

Is there another way out?  Yes. Normalize rates and take our chances. But that demands a fortitude that’s missing in the sort of jittery lever-yanking one can observe on the Fed’s balance sheet.

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