Thursday, November 29, 2018

QE, QT, the Fed's Balance Sheet, & Monetization...Did The Fed Tell The Truth?

Back in 2009, then Federal Reserve chief, Ben Bernanke, was quite clear and adamant that the Federal Reserve would not monetize the US debt.  What did that mean?  Simply put, the Fed would not use money creation as a permanent source of financing for US government spending...(nor as a means to artificially boost asset prices???).  In his own words, testifying before Congress, on this clip..."The Fed will not monetize the debt..."Subsequently, in a November 2010 speech, then St. Louis Fed president James Bullard said: "The (FOMC) has often stated its intention to return the Fed balance sheet to normal, pre-crisis levels over time.  Once that is done, the Fed will be left with just as much debt held by the public as before the Fed took any of these actions."

Seems with a bit of hindsight, almost ten years down the road, we should ask: Did the Fed monetize the debt?  Yes.  Will the Fed return its balance sheet to the $800 billion of publicly held debt it held prior to 2008?  Unequivocally, no!  The Fed is now communicating their goal is a balance sheet somewhere from 2x's to 3x's larger than in 2008 ($1.6 to $2.4 trillion...but I'll be amazed if they ever get it close to 4x's that of 2008, or $3.2 trillion).  At present, the Fed's balance sheet is still over 5x's that of 2008...Fed Chief Powell has signaled that the conclusion to the interest rate hike cycle appears to be dead ahead, with one to two more hikes remaining (perhaps December and March).  And from there, the next economic crisis in an acutely interest rate sensitive economy/financial system, will likely be at hand despite the slightest and slowest set of hikes in Fed history.

But before the next chapter begins, let's finish the overview on the current chapter, particularly noting the moonshot in public debt (red line, chart below) and then checking the monetization question.

1- Fed holdings of Treasury's (blue line) and MBS (maroon line) versus private bank excess reserves (black line).  To avoid direct monetization into the economy/financial system, the dollars digitally conjured by the Fed to buy bank held assets were supposed to be held at the Federal Reserve as "excess reserves"...but as I'll show, that's not exactly what has happened.  Since QE began, the Fed balance sheet rose +$3.18 trillion while bank excess reserves "only" rose +1.65 trillion.  This is $1.5 trillion in newly created "digi-dollars" (direct monetization) which found their way out, in search of assets.

Since QE ended at year end 2014, Fed combined holdings of Treasury and MBS have fallen by less than $300 billion while bank excess reserves have fallen nearly $1.1 trillion.  The point?  Bank excess reserves continue falling faster than the Fed's balance sheet...or put otherwise, the banks are a like a sponge and the excess reserves are being wrung out faster than the Fed's QT, like an ongoing form of QE (direct monetization).

2- Fed balance sheet (brown line), bank excess reserves (black line), IOER (Interest paid On private bank Excess shaded area), and monetization (amount above and beyond QE created and held as excess reserves by banks...yellow line).  Quite noteworthy is the ongoing rise in monetization throughout the QE and post QE periods.

3- Same as above but starting from later half of 2014 with "QE end" and "QT begin" (quantitative tightening) callouts.  In 2016, the Fed began regular rate hikes (hiking IOER's), effectively stemming the flood of excess reserves and monetization (at least temporarily) and by late 2017 undertook quantitative tightening.  But still, the pace of tightening combined with higher IOER's hasn't kept pace with declining excess reserves resulting in the maintenance of monetization.

4- What impact could declining excess reserves (resulting in monetization...with who knows what amount of leverage) have on asset prices?  Chart below shows monetization (yellow line) versus the Wilshire 5000 (black line, representing all publicly traded US stock).  FYR - A trillion and a half dollars of monetization sitting with private banks, levered anywhere from 5 to 10 times, is a quick $7.5 to $15 trillion in purchasing power?!?

5- Same as above, but from 2015 (QE end) through present.  Note, the quantity of monetization has become rather stable at the present quantity...and the Wilshire has essentially become range-bound.  Correlation?  Causation? You decide.
In the post QE era world, $1.5 trillion in direct monetization has already slipped into the economy/financial assets.  Banks still sit on another $1.6 trillion in excess reserves and the Fed pays them billions to neither lend nor invest those trillions.  However, as the Fed has now signaled they will soon cease raising rates, which is probably the pre-cursor of the next set of interest rate cuts...what are these mega-banks, presently sitting on trillions of inert dollars, to do?  Perhaps the Fed will continue to raise IOER's in an attempt to slow the release of reserves to be more in-line with the Fed's QT?  Or will the "sponge", still with $1.6 trillion in excess reserves (awaiting leverage) continue to be wrung out faster than the Fed's QT, rushing of in search of assets?  Of course, I don't know the answers but I hope to at least be asking some of the right questions.  I am quite confident this is not the cause of our problems but a coping mechanism for a terribly flawed system, as I've described previously, HERE and HERE.

Extra Credit - The chart below shows the Fed's total holdings of Treasury debt since 2007 (black shaded area) and quantities held of differing durations.  Since QE ended, the Fed's holdings have changed, as follows:
  • Total Treasury holdings...-8.5%, -$209 billion
  • 20 to 30yr holdings...-6%, -$39 billion
  • 7 to 10yr holdings...-62%, -$437 billion (-71%, -$632 billion from 2013 peak holding)
  • 1 to 5yr holdings...-12.5%, -$137 billion
  • Under 1yr holdings...+$406 billion

BTW - this chart doesn't exactly seem to line up with the "rolling off as they mature" narrative.