Sunday, December 23, 2018

Seeds of Market Collapse in the Federal Reserve's "Autopilot" Balance Sheet Normalization

A lot of talk last week centered around the potential for the Federal Reserve to revise their planned "normalization" of holdings on their balance sheet. In particular in the post FOMC press conference, Powell said, “I think that the runoff of the balance sheet has been smooth and has served its purpose and I don’t see us changing that,”...and then “The amount of runoff that we have had so far is pretty small and if you just run the quantitative easing models in reverse, you would get a pretty small adjustment in economic growth, and real outcomes.”  

Trouble is, the changes in the Fed's balance sheet to changes in asset prices are unambiguously correlated. Powell is either unwittingly wrong or, more likely, knowingly collapsing an asset bubble that was in large part created by the Federal Reserve itself.

Fed Held Treasury's
To set the table, the chart below shows the total Federal Reserve holdings of US Treasury's (blue line) and weekly changes (yellow columns) from 2003 to present.  The August '07 through January '09 period is noteworthy as the only period with a like Treasury holding drawdown to what we are presently witnessing.  The subsequent highlighted areas show the periods of no growth in Treasury holdings, or most recently the outright declines.  The most recent period represents just $230 billion reduction of a proposed $1 trillion total "normalization" in Treasury holdings.
Perhaps the reason equities tanked when Powell suggested that the Fed's plan to normalize its balance sheet was on "auto-pilot" can be seen in the chart below.  Red line is the Wilshire 5000 (representing all publicly traded US equities) and yellow columns are the weekly change in the Federal Reserve's holdings of Treasury's.  On the five occasions (highlighted again) since 2007 that the Fed has ceased buying or outright sold Treasury's, the Wilshire has gone into convulsions or outright cracked lower.

*Of course the 2016-2017 period of Wilshire gains versus no gain in Treasury holdings can perhaps be explained by "yuge" increases in deficit spending, impending tax cuts, and record corporate profits / buybacks during the tail end of ZIRP?
Fed Held MBS
To round out the picture, the growth in Federal Reserve held MBS (mortgage backed securities).  Red line is total and blue line, the weekly change, since 2009.
For comparison sake, the relatively more benign (?) impact of the change in MBS holdings on the Wilshire 5000.
And if we stack the weekly change in the Fed's Treasury and MBS holdings together against the Wilshire 5000...and extrapolate that this is just the beginning of a process that will continue until either the market collapses or the Fed has finished "normalization" sometime in 2021(?), the rush to the exits may be more easily understood.
Finally, we narrow in from 2017 through present (plus a callout for the initiation of the Fed's balance sheet reduction).  As the Fed has been ramping up its reductions, the market has become increasingly unstable even before the most recent fall began.
So What?
The Fed is communicating that they have shed less than $400 billion of perhaps a total $2 trillion "normalization".  Given the major market impacts during the relatively minor balance sheet reductions in 2007 and again at present, there is every reason to believe a 50%+ fall in the asset prices is imminent absent a policy "U-turn" by the Fed.  Of course, that "U-turn" would (will)  be an admission that the process of hyper-monetization that began in 2009 was and still is a one-way ticket.

Extra Credit: Chart below shows the change in Federal Reserve holdings of Treasury's plus MBS (five week moving average) versus the Wilshire 5000.  Draw your own conclusions regarding correlation and/or causation.