Tag Archive: Fed

Putting the Fed’s balance sheet in perspective

Along with fiscal stimulus, the aggressive support of financial markets by the Federal Reserve (and other central banks) has been a key to the gains in risk assets since April. In our view, stock and bond prices would not be as high as they are if not for the perception that the Fed will step in with additional support if markets get too volatile. This perceived “Fed put” is on top of the ongoing bond buying programs (excluding the immediate post-COVID surge) that are currently running at a rate of about $80 billion per month for Treasuries and $40 billion per month for mortgage backed securities, though some of this replaces expiring bonds.

So the Fed continues to have a heavy influence on debt markets, and thus indirectly on equity and other financial markets.

The size of the Fed’s balance sheet (the value of all assets it holds) used to be far smaller relative to the economy or the markets, and only began to be a major part of the monetary policy toolkit in 2008 in response to the Great Financial Crisis. Previously, the Fed’s control of short-term interest rates was sufficient and did not require as much balance sheet activity, but once short-term policy rates hit zero in 2008 (and again this year), new tools were needed.

The chart below plots the ratio of the Fed’s balance sheet to US nominal GDP, perhaps the most common way of putting the Fed’s monetary policy actions in perspective. From a pre-crisis level of around 6% of GDP in 2007, three rounds of quantitative easing (“QE”, or bond buying) starting in 2008 pushed the ratio up to about 25% of the size of the US economy in 2014. Then the Fed allowed some assets to “roll off” (bonds maturing and not being replaced with new ones) and effectively shrink the balance sheet relative to the economy. Several years of such a policy brought the balance sheet back to about 18% of GDP in early 2019.

Fed Balance Sheet Pct of GDP

This appears, in hindsight, to have been too small a size for the Fed’s balance sheet nowadays. It is important to recall that even before COVID hit earlier this year, in mid-2019 the Fed began lowering rates and adding to its balance sheet again to ward off interbank funding strains and signs of weakening economic growth. Then in response to the COVID-related shutdowns of the economy, the Fed made its most aggressive balance sheet movement to date. It bought nearly $3 trillion in Treasury, mortgage-backed, and other bonds very quickly, pushing its balance sheet size up to its current record level of about $7 trillion. This is now about 36% of US GDP.

While comparing the Fed’s assets to the size of the economy is a relevant comparison, we should also keep in mind that financial markets have generally grown faster than the economy. So it is also worth considering the Fed’s balance sheet in relation to the size of the debt and equity markets.

Notably, even with huge issuance of Treasuries recently to finance the US federal budget deficit, the Fed now owns over 20% of all publicly held Treasuries, more than it has in at least 20 years.

And it owns more than 30% of the mortgage-backed bond market, similar to what it owned in the aftermath of the Great Financial Crisis (which was heavily tied to the mortgage and housing market). This has helped push mortgage rates to all-time lows recently.

The chart below, however, plots the Fed’s balance sheet relative to the size of the US equity market. Now, to be clear, the Fed does not own US stocks (at least not yet, though other central banks like those in Japan and Switzerland do buy stocks), so this is just another way to scale the size of the Fed’s balance sheet (bond holdings) that may be of more interest to equity market participants.

Fed Balance Sheet Pct of US Market Cap

We compare the value of the Fed’s assets to the total equity market capitalization of the broad Russell 3000 index (the 3000 largest US companies). The picture there is notably different than the one using GDP as the scaling metric.

The initial surge in 2008-09 is very stark, pushing the balance sheet from around 7% of equity market cap up to a peak around 25%. Then the balance sheet oscillated around 20% of US equity market value as the Fed’s bond buying was roughly in line with the growth in the equity market through 2016. When the Fed began allowing its balance sheet to gradually decline, stocks continued higher and thus the Fed’s assets dropped sharply to a low of around 13% of equity market cap in 2019.

The Fed’s actions this year have provoked another jump in the ratio, but the change relative to the stock market has been less than that seen in 2008-09, due to the larger size of the stock market. The peak earlier this year was around the same 25% level relative to US equity market value, and since then the gains in stocks have outpaced the Fed’s buying of bonds and pushed the ratio back down somewhat.  The Fed’s assets now equal about 21% of US equity market value, not far from the average level during the 2009-2016 period. This reflects the fact that the stock market has grown significantly faster than US GDP in recent years as equity valuations have risen.

We can thus see that while the Fed is more involved than ever in financial markets by some metrics, by others it is not far from the ranges it has inhabited since the Great Financial Crisis started 12 years ago. And we should keep in mind that other central banks (Bank of Japan, European Central Bank) have balance sheets even larger relative to their economies or their financial markets. So the Fed could certainly continue expanding its asset purchases further before it would approach the relative size of some of its counterparts.

The Fed is thus both limited and nearly unlimited: it can print money to buy bonds (including corporate bonds now), i.e., make loans, in almost unlimited quantities, but cannot determine how the money they print is used (or not used), and cannot give outright gifts or grants. Only Congress, via the Treasury, can distribute truly “free money” that does not have to be paid back. And recent headlines suggest further delays in new fiscal policy support. That leaves the Fed as the main provider of market support, at least for now.

In case you need a refresher course, it’s all stimulus these days

*with apologies to Irwin M. Fletcher

Much has been made about the divergence between the path of the US (and global) economy and that of the stock and corporate bond markets. Even while economic and earnings growth is historically weak and remains under severe pressure from a rapidly spreading virus, major stock market indices have rallied and are at or near all-time highs. Market valuations based on forecasted earnings over the next 12 months have clearly risen sharply.

While the divergence between financial asset prices and the “real economy” as experienced by many Americans is striking, the reason is not hard to see: enormous levels of stimulus by both fiscal and monetary authorities.

Essentially, the US Congress has voted (in four separate pieces of legislation so far) to drastically increase deficit spending to support individuals and businesses as well as the costs of health care and virus abatement. The trailing 12-month US federal deficit has jumped to about $3 trillion, easily a new record in nominal terms and the largest deficit as a percentage of US GDP since World War II.

As shown in the bottom section of the chart below, the current 12-month deficit is now nearly 14% of nominal GDP, significantly more than the peak following the Great Financial Crisis, and up from the deficit levels of 4-5% of GDP in 2018-19, i.e,. adding roughly 10% of GDP to spending. This has helped fill a huge gap in personal incomes caused by lockdowns associated with COVID-19.

US Monetary and Fiscal Stimulus

And crucially, at the same time, the Federal Reserve has also engaged in an unprecedented level of money creation (“quantitative easing”, or QE) to essentially monetize the increase in Treasury debt. After immediately cutting its fed funds policy target back to zero (0 – 0.25%), the Fed has expanded its balance sheet from around 20% of GDP before COVID-19 hit to over 30% of GDP currently, i.e., adding roughly 10% of GDP to the money supply. This is also far bigger than its balance sheet was after the three previous rounds of QE between 2008 and 2014.

While the Fed has a number of different programs in place to support financial markets and the economy, most of what it is doing is buying up Treasury bonds, mortgage backed securities, and more recently corporate bonds and bond ETFs. It does this with newly created money that can then circulate in the economy. A key effect is to essentially offset the absorption of money caused by the Treasury issuing huge amounts of new bonds, and has drastically expanded the US money supply. And by using newly-granted powers (under the recent CARES Act) to buy corporate debt (including some high-yield or “junk” debt), it has also compressed the credit spreads in the corporate bond market and made it cheaper for companies to borrow than it otherwise would be.

So an extreme oversimplification would be that the Treasury engaged in new spending of something on the order of 10% of GDP, and the Fed printed roughly a similar amount of new money to “pay” for it (a liquidity conversion of the Treasury bonds to cash), with some of that Treasury money being used to allow the Fed to take on corporate credit risk for the first time. That extra ~10% of the economy that has been conjured up by Congress and the Fed was meant to fill some of the hole left by the meteor that hit the global economy in the form of COVID-19.

The key question now is to what degree is additional stimulus needed, and will policy makers provide it to the appropriate degree? Current virus trends, structural economic damage COVID-19 has already caused, and rising debt levels suggest significant further stimulus will be required to bridge the gap until the economic effects of the virus have passed, though that remains a point of debate.

Investors who take the view that the policy response will be sufficient (or possibly even excessive) are likely those who are content to pay the same (or higher) prices for stocks and some bonds than they did in 2019, and assume that earnings will fully recover and stocks will be worth more in the future due to the lack of any competition from near-zero interest rates on safe debt (Fed policy rates are expected to remain near zero for several years at least).

Investors who worry that the policy response will falter may be more cautious, given the potential further weakness in corporate earnings that would also result. And one outcome in particular bears consideration: what if the fiscal response falters (due to Congress being unable to agree on sufficient stimulus legislation), but the Fed continues to intervene heavily in financial markets with quantitative easing and corporate credit spread compression (i.e., printing more money than can readily be spent)? Then financial assets, and unprofitable companies, might continue to hold up and inflation could eventually rise, even while the underlying economy weakens (with implications for income and wealth inequality).

That is arguably not far from what is happening now, as the Fed has adopted a “whatever it takes” approach and has few limits to the amount of monetary support it can provide. The question of further fiscal stimulus is the key question right now, as there reportedly remains a wide gap between Democrats and Republicans in Congress (and the White House) about the size and scope of any additional stimulus. With much of the original stimulus plans now fully utilized or expiring soon, there is a clear danger of a de facto sharp contraction in fiscal policy relative to the current extreme levels of support (the so-called “fiscal cliff”). Congress is scheduled to be in session for only a couple of weeks before going on August recess, and the key $600/week of extra unemployment benefits are due to expire on July 25th. The path of the economy and financial markets may depend on decisions made by Congress in the next few weeks.