Thinking Through The Fed Balance Sheet

Brandon Snow's picture

Recently, there has been a lot of discussion about the U.S. Federal Reserve balance sheet as markets were driven to confusion over the anticipated reduction of the Fed’s economic stimulus measures. I asked two of Cambridge’s newest team members, Analysts Danesh Rohinton (global securities in the financials sector) and Grant Connor (fixed-income), to offer their perspective on the situation and highlight the risks as we see them. Here is a summary of their insights.

Central banks are required by law to maintain a minimum level of liquid assets (e.g. cash or deposits). This is known as required reserves. Historically, banks would maintain no more than the minimum level of required reserves and lend out the rest. With the onset of the financial crisis, the U.S. Federal Reserve began pumping money into the banking system at an unprecedented pace. Initially, this was done to stabilize the industry by providing liquidity. Later, the intent was to stimulate the economy by lowering interest rates.

However, the U.S. banking system has parked most of the funds at the Federal Reserve rather than deploying it into the real economy. Three rounds of quantitative easing have resulted in adding nearly $2.4 trillion to the Fed balance sheet. The vast majority of it represents excess reserves which earn a negligible interest rate of 0.25% per year (see chart below). Over the last 12 months, the Fed balance sheet grew by $966 billion but only $83 billion entered the real economy, while the remaining $883 billion was deposited by the banking system as excess reserves.

Based on conversations with management teams at U.S. banks, we believe the funds have not been deployed into the economy due to a lack of demand for loans from qualified borrowers and the unwillingness by the banking industry to loosen lending standards. However, if an economic recovery increases the demand for credit among qualified consumers and businesses or fosters greater credit risk appetites among lenders, then banks may begin to loan out their idle funds. If these idle funds enter too quickly into the economy, there is a risk of rapid inflation because of “too much money chasing too few goods” (to borrow from Milton Friedman).

Thus, the Fed faces a delicate balancing act. It must normalize its balance sheet by reducing the excess reserves of banks in order to lower the risk of rapid inflation. But it must do so at a pace that does not push up interest rates so quickly that it would smother a recovery. To strike this balance the Fed has two primary tools at its disposal. The first tool would be for the Fed to influence interest rates by adjusting the pace of treasury and mortgage-backed securities sales to absorb inflationary excess funds in the economy. The second tool is for the Fed to increase the 0.25% interest rate it pays on excess reserves of banks. This would incent banks to keep funds idle by lowering the opportunity cost of not lending it out, which should slow the potential inflationary flow of money into the economy.

Over the last five years, we have seen an unprecedented expansion in the Fed’s balance sheet. Initially, we do believe it was the right thing to do in order to avoid an economic collapse. However, the longer monetization goes on and the larger the balance sheet gets, the more risky the exit becomes. As you all know, we are bottom-up investors at heart but in these extraordinary times it’s important to have a macro framework to invest within. While a macro framework can’t determine the companies we should own in the Cambridge funds, it does help us to understand the risks facing the market.

Comments

Submitted by John Louko on

Australian economist Satyajit Das has said that "We will be in QE forever." If that were to come to pass, the exit risk would go through the roof, or there would be no exit ever. Please comment.

Brandon Snow's picture
Submitted by Brandon Snow on

The purpose of ongoing QE is to help break the vicious cycle of poor sentiment curbing investment and consumption. From our conversations with management teams and evidence from recent research conducted by the National Federation of Independent Business (NFIB), we have seen an improvement in confidence, albeit in an uneven manner. We believe the Fed is aware of the destabilizing effects of "QE forever" across asset classes and would be ready to taper once the improvement in sentiment has met its criteria.

The unlikely scenario of "QE forever" would run the risk of destroying the sanctity of the capital system and debase the concept of fiat currency – which would be a very negative outcome. Before we get to that point, the bond market will likely say enough is enough and dictate to the Fed that it is time to tighten. Keeping an eye on inflation expectations, the U.S. dollar and bond yields can help us see if the Fed is losing control of the situation.

The idea that the Fed will be forever printing money is a great topic of discussion for dinner parties, gold bugs and market bears but it isn't investable. While we always build a macro framework for us to understand the potential risks, our final investment decisions come down to our bottom-up fundamental analysis. Our philosophy allows us to participate in the value creation of quality businesses while monitoring the macro framework so we can adjust the Cambridge funds accordingly.

Submitted by Bob Rafuse on

Given the unsustainability of the current situation, when tapering does begin, which do you see being most impacted: bond funds or equity funds? Would you expect one to react more quickly than the other?

Enjoyed your talk in Montreal this week. Few speak so clearly and directly. Thanks

Brandon Snow's picture
Submitted by Brandon Snow on

The focus on QE tapering in isolation is causing the Fed's intentions to be forgotten. I believe the Fed understands that tail risks rise as they continue to buy bonds. However, the reason they continue to do so is because those funds are not making it into the market: it’s not about the price of capital it’s about the availability of capital. At Cambridge, we continue to think that in conjunction with tapering the Fed will entice banks to get the reserves off its balance sheet and into the economy (increased lending). In this scenario, you could see flat or rising bond yields while growth accelerates and equities would benefit.

Unfortunately, there are many potential outcomes from a macro perspective which makes it tough to invest based on a top-down view. This is why we focus on bottom-up fundamentals while keeping an eye on macroeconomic risks.

Thanks again for the support,
Brandon

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