At his recent dog and pony show with the beloved Wall Street media crowd, Fed Chair Powell laid out the outlines of a supposedly new policy. He said the Fed would adjust the rate of the bloodletting of its balance sheet under “normalization,” in response to bad things that might happen in the financial markets. He did this apparently because it has suddenly been revealed to the Fed through their keen powers of observation that “bad” market behavior might, just might, be related to that balance sheet “normalization.”
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Will wonders never cease.
Now, lo and behold, we discover that that which Mr. Powell said the Fed might do, it has already started to do. The Fed has already started to slow the bloodletting — the rate at which it shrinks its balance sheet and pulls money out of the banking system.
But does that matter? Read on to find out, and what to do about it.
Draining Money From the System Leads to Earthquakes
Under the “normalization” program, the Fed has shrunken its balance sheet by $443 billion since October 2017, when it started. That’s $443 billion that it has pulled out of the banking system and extinguished. In the process we have so far seen two market earthquakes, one last February, and a far bigger one in the fourth quarter of last year. The markets mounted rapid recoveries from both.
Only they’re not complete recoveries. Remember when the 10 year Treasury yield was at 1.4%? That was a long time ago, 2016 to be exact. One day we’ll be looking back at the S&P being at 2940 just as wistfully.
The Fed’s drains don’t show up on my trusty old Fed Cash to Primary Dealers Chart that had been my bread and butter since 2002, because the drains, as shown in the above chart, do not involve direct trades with the dealers. That’s the old way of managing monetary policy, called Open Market Operations (OMO). OMO is just economists’ way of saying that the Fed is buying and selling securities directly and solely with Primary Dealers. That was the way the Fed had executed monetary policy for a couple generations.
In 2008, the Fed tried an end-around, bypassing the Primary Dealers and going direct to the end users of the cash injections. We saw how that worked – a horrendous bear market, that included the September 2008 crash, and that didn’t end until March 2009.
Now, the Fed is doing another end-around the dealers. But this time instead of starving them out, it’s cutting them a break. It could cut its balance sheet down to size by selling its Treasury note and bond holdings and MBS directly to the Primary Dealers. That would have sucked cash out of dealer accounts and almost certainly would have had the effect of causing an instant catastrophic crash. Dealer cash is the lifeblood of the markets. Without it, lots of it, they can’t make and maintain orderly markets.
So the Fed opted for an indirect method, which was to allow its securities portfolio to shrink by attrition. As its Treasury holdings mature, it simply tells the Treasury to repay the loan represented by the note or bond. So the money comes out of the banking system via the conduit of the US Treasury, not the Primary Dealers.
The Treasury must sell more notes and bonds to raise that cash, and ultimately the dealers do provide some of that cash by purchasing some of those notes and bonds. The amounts depend on how much demand comes from other investors, like investment funds, and foreign central banks. When third party demand is weak, the dealers are forced to take on more inventory.
To be able to do that, the dealers lower their bids, sometimes radically. Bond prices fall and yields rise when that happens. At one point last year the 10 year had soared to 3.25%. But then the selling panic switched to stocks and money rotated back to bonds. The dealers got a reprieve as the 10 year rallied to 2.6%.
That reprieve may not last much longer, as investors rotate back into stocks, and more Treasury supply keeps pounding the market.
Fed is So Worried It Has Already Done What It Said It Might Do
Meanwhile, in reviewing the Fed’s balance sheet this week, I calculated that the Fed is approximately $60-70 billion behind its published “normalization” schedule. Over the most recent 3 months, the balance sheet shrank by just $116 billion, which is $34 billion less than was expected under the Fed’s published “normalization” schedule.
In the 4 weeks ended February 6 the Fed reduced its balance sheet by only $30 billion, not the $50 billion that was scheduled.
The total amount of drains scheduled since the program began in October 2017 through the end of January was approximately $500 billion. With only $443 billion put out of its misery, it appears that the Fed may have already begun to slow the draining process.
90 days ago, the Fed held $94 billion in Treasury securities that were due to mature within 90 days. The normalization schedule of up to $30 billion per month in Treasury redemptions would have allowed for virtually all of it to be redeemed.
But it wasn’t all redeemed. The Fed redeemed just $65 billion of that paper, holding on to $29 billion of it that it was supposed to let go. So it pulled that much less cash out of the system than it had scheduled.
Nevertheless, regardless that the Fed has slowed down a bit, it is still pulling cash from the system. And that is still a problem.
It certainly looks as though the Fed was in fact spooked by the December stock market plunge and threats from the Trump Regime. It has demonstrably slowed the rate of bloodletting, without admitting that it has. It only said that it could, or would, in response to the market or economy. “Could, should?” Oops, already doing it.
Meanwhile, the dealers are still being forced to buy massive amounts of new Treasury supply as the government’s budget deficits soar. This is exacerbated by Treasury needing to sell additional debt to pay back the Fed for the maturing paper that it is no longer rolling over in perpetuity.
Here’s the Real Problem the Fed is Worried About
In being required to absorb this constant tsunami of new Treasury supply, the dealers are building up ever larger record long positions of Treasuries in their securities inventories. At the same time, they are hedging those positions by shorting Treasury note and bond futures in record amounts.
When bond prices are stable or rising (yields stable or falling), no problem. Nothing to see here. Move along. All is well.
But sooner or later the market will go the other way as Treasury supply continues to pound away at the market’s ability to absorb more and more and more paper. It means that these dealer hedge trades will at some point need to be unwound. The short futures will be bought in, and the long Treasury positions will be sold. That unwinding could be sudden and disorderly.
I think that this is a ticking time bomb. We just don’t know when it will go off.
I suspect that this is the real reason that the Fed reversed course last week, not some garbage excuse about maybe the economy is slowing. That’s a red herring.
The fact that the Fed isn’t draining quite as much as its schedule projected does not matter to the market. It’s still draining. With the Treasury still issuing massive amounts of T-bills, interest rates should remain under upward pressure regardless of whether the Fed rubber stamps the moves or not.
So don’t get bullish on stocks and bonds just because the Fed might be draining less. For now, I think that preservation of capital must remain the name of the game. I still like the idea of holding and rolling T-bills.
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