The Fed's Balance Sheet Update
(February 26, 2010)
Dear Subscribers and Readers,
I hope this commentary finds you well. While the stock market did not manage to recover all its losses yesterday, it did retrace most of the early morning breakdown. At one point, the Dow Industrials was down nearly 190 points, the Dow Transports nearly 90 points, and the S&P 500 nearly 20 points. The Dow Transports actually managed to close positive for the day, closing up 0.44% to 4,113.81 – its highest level since January 20th. This strong technical action – especially coming in the face of disastrous economic news (high initial claims, lower consumer confidence, the Greek fiscal crisis, weak mutual fund inflows into the domestic equity market, etc.) – is a great positive for the U.S. stock market. To reiterate – the cyclical bull market that began on March 9, 2009 remains intact. In the short-term, the U.S. stock market is most likely in a consolidation phase, as investors still need to digest the long-term implications of the Greek fiscal crisis, high debt levels in the developed world, a tightening People's Bank of China, and stubbornly high commodity prices (with the glaring exception of natural gas, of course). Sometime in the next couple of months, I expect the bull market to resume – although any upcoming rally will likely be tepid compared to the rally of 2009.
Aside from the action in the U.S. stock market, other issues that we have covered over the last few weeks include:
- The Greek fiscal crisis – and more important, its long-term implications on the global financial markets and the global economy;
- The “true intentions” of the Fed – we asserted that the Bernanke Fed is still not close to tightening monetary policy, and in fact, still has some “fire power” up its sleeves should the market falter going forward;
- The impact of a tightening People's Bank of China on the global financial markets, especially commodities. We will revisit this issue sometime in the next few weeks;
- The potential upsurge in inflationary pressures in India, and whether this is a prelude to tighter budget spending in India and beyond (as well as other tightening measures).
I will cover the ongoing fiscal crisis in Greece and the latest Fed liquidity numbers in this commentary – and possibly move to the topic of Chinese liquidity or (the next sources of) U.S. Schumpeterian growth in this weekend's commentary. As I am typing this, European Union inspectors are still in Athens trying to assess Greece's financial/fiscal situation and whether the planned austerity measures (assuming the country is not shut down by strikes again) are sufficient to reduce the Greek budget deficit by 4% this year.
The Greek government has so far raised €14 billion this year, or about 25% of its €55 billion in this year's financial needs. More important, there are €20 billion in Greek government bonds maturing in April and May. Moody's and S&P have already gone on record stating that it will cut Greece's credit ratings (possibly as early as the end of next month) should a “weak economy and political opposition” to the government's austerity measures usurp the country's ability to cut its budget deficit. This is an important point, as any further spike in Greek interest rates really has little impact on the Greek budget in the foreseeable future (e.g. if Greek interest rates rise by 1%, this will only impact the €40 billion in new financing this year, for an additional €400 million in interest payments – all its previous debts would incur the same interest payments until they come due). Greece remains in a fluid situation, as any substantial government budget cuts or an increase in taxes could further retard economic growth – thus impeding the government's ability to lower its debt load or grow out of it (from a percentage of GDP standpoint). In addition, many European citizens will not hesitate to strike again should the government plans for more cuts. My sense is that the European Union (i.e. Germany and France) would come in and help Greece should it make a “good faith” effort in cutting its budget deficit. At this point, I still do not expect the Greek fiscal crisis to evolve into any kind of systemic event (note that the Goldman Sachs' Euro Zone Financial Conditions Index has just made another low not seen since August 2007, signaling that liquidity/monetary conditions in the Euro Zone – which includes Greece – is at its easiest level since August 2007), although the markets will likely remain jittery for the foreseeable future.
Let us now take a close look at the status of the Fed's balance sheet. Total Reserve Bank credit now sits at $2.27 trillion, up $5.2 billion from last Wednesday, and up $369.3 billion from a year ago (when the financial crisis was at its height). The fact that the size of the Fed's balance sheet has increased despite the recapitalization of banks' balance sheets and the rally in global asset prices suggests two things: 1) The Fed is hell-bent on rejuvenating the U.S. economy by flooding the global financial system with ample liquidity (which has been obvious for awhile now), and 2) Unlike prior global financial panics (such as the Panic of 1907 or even the 1997/1998 Asian/Russian/LTCM crises), the aftermath of this current “panic” is very different in that the major central banks around the world have stepped up and corporated by flooding the global financial system with liquidity. In addition, the mix of the Fed's balance sheet has shifted substantially as the Fed has shifted its focus from providing direct liquidity to the banking system and other central banks (such as the Bank of Korea) to providing direct liquidity to the broader system/economy through the purchase of U.S. Treasuries, agency debt and agency MBS under its credit easing program. Over the last 12 months, the Fed has purchased a whopping $1.396 trillion of such securities.
In total, the Fed has made a commitment of purchasing $1.25 trillion in agency MBS and $175 billion of agency debt by the end of March. As of Wednesday afternoon, the Fed still has $226 billion left under this commitment, although it is not obligated to purchase the full amount (assuming it purchases the whole commitment, the Fed would need to purchase an average of $45 billion in agency debt and agency MBS over the next five weeks). More important, the Fed has not slowed down its purchases over the last couple of weeks, even as it raised the discount rate by 25 basis points. As shown on the following chart, the Fed purchased an additional $61.9 billion of agency debt and agency MBS over the last two weeks:
In our mid-week commentary last week, we asked: “So does the latest move mean that the next cycle of tightening is upon us? I recommend a wait-and-see approach. Sure, the Fed is not easing anymore. It has also hiked the discount rate by 25 basis points, but it is by no means tightening just yet. With banks still refusing to lend, with China still tightening, and with Western Europe and Japan still mired in a deflationary cycle, it is still difficult to see global inflation popping up anytime soon. Moreover, the fact that the Fed has kept open its credit easing program suggests that the Fed still has its eyes on the trigger, especially if risky assets such as global equities or corporate bonds start to dive again. In the meantime, I expect the U.S. stock market to be stuck in a consolidation phase for the foreseeable future, despite the strong rally we experienced over the last few trading days.”
Bernanke's testimony to the Congress on Wednesday signals that the Fed isn't close to tightening – confirming our suspicions expressed last week. Given the ongoing troubles in the developed world, Chinese tightening, and a still paralyzed U.S. banking system, I continue to expect the Fed to stand ready to purchase more assets under its credit easing program, as needed.
Henry To, CFA