2018_08_09 — “Don’t be Fooled by the Fed’s Shrinking Balance Sheet”

August 9, 2018

Don’t be Fooled by the Fed’s Shrinking Balance Sheet

  • The Fed is on its well announced path to shrink its balance sheet with quantitative tightening (QT)
  • Structural changes will the force the Fed to maintain a higher balance sheet down the road as it’s now the world’s liquidity provider
  • Thus, the Fed will never return to the pre-crisis normal of a balance sheet less than $1 trillion
  • Therefore, it may also be an extremely long time till U.S. interest rates return to their pre-crisis norm

Prior to the great financial crisis of 2008, the Fed ‘s primary role in a crisis was as lender of last resort, but during the period of quantitative easing (QE), the Fed also became the primary provider of global liquidity. Fed balance sheet assets swelled from less than $1 trillion (approximately 6.5% of GDP) to nearly $4.5 trillion (approximately 24% of GDP). But now the Fed is in a self-declared and self-directed period of quantitative tightening (QT) where it regularly shrinks its balance sheet of treasuries and mortgages by selling them to the market.

Most normalization projections from analysts and research houses show the Fed balance sheet smoothly declining because of QT to $1.5 to $2 billion my mid-2022. Maybe this will happen, but long term, higher Fed balance sheets are here to stay for several reasons.

  • If an economic crisis erupts between now and the completion of QT may be halted or reversed
  • Furthermore, there has been a structural shift higher in the amount of required reserves for regular regional and national banks, thus they won’t be able to fuel the economy as much as in the past
  • Third, if economic momentum remains on track, savings surpluses are possibly set to reverse and start to decline

One of the paradoxes of the post-financial crisis regime was that as interest rates declined, savings swelled. Most pundits had projected that low interest rates would dissuade people from saving money in a bank and nudge them to take risk, but the opposite happened. Since interest growth was lacking, low interest rates incentivized people to save even more money in order to meet their future financial needs.

Now, as U.S. and international interest rates rise, people will be inclined to save less. Higher interest rates, aging populations, and increased capital expenditure (capex, which goes hand in hand with economic growth) will cause savings to shrink. As U.S. and global savings surpluses shrink, growth capital for expansion and new business ventures will become more expensive. Private industry will also compete with increased government expenditures, further increasing capital costs.

As foreign capital to support sustained U.S. growth becomes more expensive, the Fed’s balance sheet will swell to an even larger percent of GDP in its attempt to achieve a magical balance between economic growth, unemployment, and inflation. Thus, the balance sheet shrinkage occurring with quantitative tightening (QT) is a short term adjustment, but certainly won’t lead to the old pre-crisis normal Fed balance sheet of less than $1 trillion nor of approximately 6.5% of GDP. A trough balance sheet range of $2.5 to $3.5 trillion (approximately 13% of GDP) is a good near term projection over the next several years before the balance sheet starts to swell again in order to support normal economic growth, a financial crisis, or global liquidity. With both the Fed and the market accustomed to higher balance sheets, interest rates will probably not climb to their old pre-crisis levels for a very long time.

Michael Ashley Schulman, CFA

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Disclosure: The opinions expressed are those of Michael Ashley Schulman, CFA and are subject to change without notice. The opinions referenced are as of the date of publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward-looking statements cannot be guaranteed; neither can backward-looking nor current-looking statements. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.

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Michael Ashley Schulman

Avid traveler and art fan, also Partner & Chief Investment Officer @Running Point Capital, a multifamily office and ultra high-net-worth money-management firm