Fed’s research risks a liquidity storm
Yikes! Did the U.S. Federal Reserve (Fed) just propose a material reduction in its balance sheet?
After the war is over, investors will revert to concentrating on earnings and other thematics again, and a recent Fed research paper may give investors something to worry about.
The U.S. Federal Reserve once had a small presence in the financial markets, it was a mere footprint. Since the global financnial crisi (GFC) and thanks to quantitative easing (QE), and perhaps even Modern Monetary Theory (MMT) the Fed’s balance sheet today is a giant boot – maybe a steel-capped Blundstone.
The recently published Fed research paper, entitled “A User’s Guide to Reducing the Federal Reserve’s Balance Sheet,” outlines a roadmap to reclaim that smaller profile.
The paper suggests a reduction of between US$1.2 trillion and US$2.1 trillion, aiming for a mid-point of US$1.7 trillion, all while purportedly maintaining the ‘ample reserves’ framework that has defined the post-2008 era and supported markets since the GFC. Sounds good?
Not according to CrossBorder Capital’s Michael Howell, who says in a post last week that the Fed’s idea may be less of a roadmap and more of a mirage that ignores the realities of modern market liquidity, adding, “For the plan to work, the US Treasury and Fed would need to establish a level of supply coordination, and the private sector a level of demand [certainty], that rarely exists in practice.”
The maths of market oxygen
To understand Howell’s scepticism, a 101 Liquidity Explainer might be useful. Importantly, and in the first instance, liquidity is much more than a pile of cash sitting in a bank vault.
Howell’s definition is:
liquidity = assets/duration
In Howell’s framework, liquidity increases when the pool of assets grows or when the average duration of those assets shrinks.
The Federal Reserve influences this through ‘maturity transformation’ – changing how long the private sector must hold onto its money. When the Fed shrinks its balance sheet, it is effectively draining the “oxygen” out of the money markets.
The Fed’s proposal assumes this reduction can be handled surgically, but Howell argues that shrinking the balance sheet is never a neutral policy. Because Fed Liquidity – a measure of effective injections into the market – has historically been closely tied to asset prices, a sudden drop toward the proposed US$1.5 trillion threshold could, according to Howell, spell disaster for the S&P 500, which in turn would send global equities spiralling.
Fed quantitative easing (QE) vs. treasury QE
The Fed doesn’t not operate in a vacuum, though it would seem its research papers often suggest it does. Howell highlights a crucial and relevant coordination problem between the Fed and the US Treasury. While the Fed manages the duration side (the denominator) of the liquidity equation, the Treasury manages the ‘asset’ side (the numerator). If the Fed retreats, the Treasury must step in to fill the void by issuing more short-term bills. This shift, which Howell characterises as moving from the more ‘conventional’ Fed QE we’ve all come to understand since the GFC, to ‘Treasury QE,’ requires a level of synchronism between the two independent bodies that has rarely been displayed in practice.
For example, if the Fed aggressively shrinks its balance sheet while the Treasury fails to offset that drain with a sufficient issuance of bills, the net result is a liquidity vacuum.
The Fed’s paper assumes the private sector will naturally step in to fill the gap, but Howell’s post warns that the private-sector expansion necessary is rarely automatic or of sufficient scale. Without a unified front, the transition risks leaving the banking system brittle, with balance sheets holding fewer reserves and becoming more sensitive to sudden exogenous shocks.
The peril of the inelastic curve
Perhaps the most alarming part of Howell’s critique is related to the demand for bank reserves. Howell notes the Fed’s proposal assumes a ‘static’ environment in which the demand curve for reserves simply shifts left as the balance sheet shrinks and the market remains stable. But this ignores the “precautionary surplus demand” for liquidity in times of stress, when banks and investors don’t just want ‘enough’ liquidity to function; they want an excess to feel safe.
As the supply of reserves is drained, even a tiny shift in demand or a small hiccup in supply can lead to massive, violent swings in interest rates.
We saw a preview of this in the repo market spike. In a similar spike in 2019, the Fed lost control of its target rate almost overnight. By ignoring the volatility of private-sector demand and focusing only on transactional requirements, the Fed may be walking the economy into a trap in which it is forced to choose between abandoning its balance sheet targets or losing its operational credibility.
A risky return to the past
Ultimately, Howell reckons the Fed’s research paper (not quite a proposal) is a nostalgic attempt to return to a simpler era of central banking that no longer exists.
By treating balance sheet adjustment as a technical exercise in operational efficiency rather than a policy shift, the Fed is missing the ‘wealth effect’ that falling asset prices could have on the broader economy and therefore demand.
If the Fed drains US$1.7 trillion from its balance sheet, thereby creating a more fragile market environment, the resulting spike in borrowing costs and market volatility would undermine the very stability the Fed seeks to preserve.
It could all be moot, of course, especially if the War is prolonged. But if the war ends soon, watching liquidity will be as important a litmus test of equity market support as the ballooning US debt in the absence of China buying US Treasuries.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
