In September 2017 the US Federal Reserve announced that it would finally begin shrinking its $4.5 trillion balance sheet. So how has the Federal Reserve balance sheet reduction affected asset prices since then? How has the Fed stance on its balance sheet changed so far in 2019?
Firstly, What is the Federal Reserve Balance Sheet and How Did it Get So Huge?
“When the Global Financial Crisis started in 2008, the Federal Reserve (along with just about every central bank in the world) took the unprecedented step of conjuring trillions of dollars out of thin air.
In the Fed’s case, it was roughly $3.5 trillion, about 25% of the size of the entire US economy at the time.
That’s a lot of money.
And after nearly a decade of this free money policy, there is more money in the financial system than ever before.
Economists have a measure for money supply called “M2”. And M2 is at a record high — nearly $9 trillion higher than at the start of the 2008 crisis.
Now, one might expect that, over time, as the population and economy grow, the amount of money in the system would increase.
But even on a per-capita basis, and relative to the size of US GDP, there is more money in the system than there has ever been, at least in the history of modern central banking.
And that has consequences.
One of those consequences is that asset prices have exploded.
…Why are investors paying more money for shares of a business that isn’t much better than before?
There’s really only one explanation: there’s way too much money in the system.
All that money the Fed printed over the years has created an enormous bubble, pushing up the prices of assets to record highs even though their fundamental values haven’t really improved.
As the Wall Street Journal reported yesterday, “Financial assets across developed economies are more overvalued than at any other time in recent centuries,” i.e. at least since 1800.
Investors are paying far more than ever for their investments, but receiving only marginally more value in return. And they’re actually excited about it.
This doesn’t make sense. We don’t get excited to pay more and receive less at the grocery store.
But when underperforming assets fetch top dollar, people feel like they’re wealthier. Crazy.[On 20 September 2017 the Fed formally announced] that after nearly a decade, it’s going to start vacuuming up a lot of that money it printed in 2008.
Bottom line: they’re going to start cutting the lights and turning off the music.
And given the enormous impact that this policy had on asset prices, it would be foolish to think its reversal will be consequence-free.”SovereignMan: Today the music stops – 20 September 2017
The Federal Reserve Tried to Convince the Public that “Quantitative Tightening” Would Have No Impact
Jim Rickards pointed out how the Fed wanted us to think that the reduction of its balance sheet a.k.a. quantitative tightening (QT) would have no impact:
QT1 Will Lead to QE4
“The Fed wants you to think that QT will not have any impact. Fed leadership speaks in code and has a word for this which you’ll hear called “background.” The Fed wants this to run on background. Think of running on background like someone using a computer to access email while downloading something on background.
This is complete nonsense. They’ve spent eight years saying that quantitative easing was stimulative. Now they want the public to believe that a change to quantitative tightening is not going to slow the economy.
They continue to push that conditions are sustainable when printing money, but when they make money disappear, it will not have any impact. This approach falls down on its face — and it will have a big impact.
…The decision by the Fed to not purchase new bonds will be just as detrimental to the growth of the economy as raising interest rates.
The Fed’s QT policy that aims to tighten monetary conditions, reduce the money supply and increase interest rates will cause the economy to hit a wall, if it hasn’t already.
…Because they’re getting ready for a potential recession where they’ll have to cut rates yet again. Then it’s back to QE. You could call that QE4 or QE1 part 2. The Fed has essentially trapped itself into a state of perpetual manipulation.
…Is this thing ready to pop? Absolutely, and QT could be just the thing to do it.Via Jim Rickards at The Daily Reckoning
So What Impact Did the Federal Reserve Balance Sheet Reduction Have in 2018?
Here’s a chart tracking the Fed quantitative tightening so far. The drop during 2018 is clearly visible.
Total Federal Reserve Assets
How Did This Fall Impact Other Asset Prices?
As we noted in our 2018 in review:
“A Deutsche Bank study reported that 94% of all assets lost ground in 2018. The same study also said that 2018 took first place from the old ‘winner’ of 84% way back in 1920!
Bitcoin and cryptocurrencies plummeted after being all the rage in late 2017. Sharemarkets fell across the globe too.”
Deutsche Bank concluded:
“This is what happens when the vast majority of global assets are expensive historically due to extreme monetary policy… It’s perhaps not a surprise that in this time major… central banks have moved from peak global QE to widespread QT.”The Daily Reckoning
What Effect Will the Fed Balance Sheet Reduction Have in 2019?
“The Fed’s balance sheet has been reduced by US$375 billion in the past 14 months.
That balance sheet is scheduled to fall by another US$600 billion this year and US$600 billion the following year, until the balance sheet reaches a level of US$2.9 trillion by the end of 2020.
This kind of extreme balance sheet reduction is entirely experimental.
It has never been attempted before in the 106-year history of the Federal Reserve.
Analysts estimate that reducing the balance sheet by US$600 billion per year (the current tempo) is equivalent to increasing the fed funds target rate by 1% per year.
This implied rate hike comes on top of the 0.25% rate hikes the Fed has been announcing every quarter.
QT and actual rate hikes taken together are increasing rates by 2% per year from a 2.5% base, an extreme form of monetary tightening.
The Fed is tightening into weakness and will have to pivot towards easing once it becomes obvious.
But it may very well be too late.
The bottom line is that uncertainty reigns and it’s not going away anytime soon.
Investors should ride this out with a combination of long-volatility strategies, safe-haven assets, gold and cash.”The Daily Reckoning Australia
But Now it’s Not Just the Fed Reducing its Balance Sheet
But now it’s not just the US Federal Reserve that’s unwinding its quantitative easing.
In 2018, 43 central banks tightened their monetary policy…while 32 banks eased.
That reversed the pattern of the previous 10 years, when the number of central banks cutting rates outshone the number daring to raise as everyone tried to juice their economies.
The below chart from PIMCO clearly shows many other central banks have also been reversing course and reducing their balance sheet size during 2018.
Global Central Bank Balance Sheets Since 2003
Greg Cavanan in his Rum Rebellion eletter also had an interesting chart. This showed how the European Central Bank (ECB) QE was making up for the flatlining of the Fed balance sheet since 2015. See the chart below.
He then theorises:
“The ECB is the one to worry about. The chart above is in US dollars and doesn’t show the ECB’s balance sheet being around record highs in euros (4.67 trillion euros at the end of 2018).
But now, ECB QE is over. There will be no more monthly bond purchases to monetise existing debt. Given the ECB was the major liquidity provider to the globe while the Fed engaged in QT, what will it mean for markets in 2019?”Source: The Rum Rebellion
What to Do to Protect Yourself from the Impacts of the Fed Balance Sheet Reduction?
So the data from 2018 seems to show that the Federal Reserve Balance sheet reduction or quantitative tightening had a detrimental effect on many markets.
With other central banks also now following suit, we pointed out at the start of the year that 2019 could be a volatile year.
Jim Rickards pointed out what action he recommended taking to protect yourself:
“For now, it’s not clear which way things will break next.
Volatility is back and markets are still in a precarious position.
Fed chairman Jay Powell threw markets a bone two Fridays back when he basically said all rate hikes are off until further notice and that he’s willing to scale back QT ‘if needed’.
Markets have naturally rallied since Powell’s remarks.
If you still need proof that today’s rigged markets still require support from the Fed, here it is.
But it’s far from clear the next crisis can be avoided at this point.
You don’t want to be heavily exposed to these markets.
It’s far better to get out too early than too late.
You should not be the last to get ready. Start now to decrease equity allocations and increase your allocations to cash and gold so you can weather the coming storm.
Preparation means 10% of your invistable [sic] assets in gold or silver and another 30% in cash.
That allocation should preserve wealth and provide dry powder for bottom-fishing in the crisis to come.”The Daily Reckoning
Balance Sheet Reduction is (Almost) Over
This advice from Rickards now appears timely. It does indeed look like the damage has already been done by the Feds Q.T.
So much so, that the Federal Reserve announced on 20 March 2019 that there would be no further interest rate hikes in 2019.
But on top of this, that the Fed would also cease its balance sheet reduction at the end of September. Source.
The Fed has now set a reduction schedule of $50 billion in April and then a reduction to $35 billion for each of the next five months through September. This is an additional $225 billion in Fed tightening, which would take the balance sheet down to $3.731 trillion.
This is quite a long way from their original aim of 2.9 trillion by the end of 2020.
They also made mention that they may restart the balance sheet reduction down the track. But if the U.S. and global economies are slowing, that seems pretty unlikely.
What Happens Next?
We theorised back in January this change in tack might not be far off, given that many economies around the globe (including here in New Zealand) appear to be slowing.
Now before too long the central bankers will likely have to reverse course and reopen the money spigots.
Perhaps they will also come up with even more new ways to interfere and prop up markets. As Rickards points out, this is the sort of environment that will likely be gold positive.
Browse the available options to buy gold here.
To learn more about the role gold may play in the global monetary system check out this article: If/When the US Dollar Collapses, What Will Gold be Priced in?
Editors Note: This article was first published 26 September 2017. Updates 15 January 2019 to include the sections: What Impact Did the Federal Reserve Balance Sheet Reduction Have in 2018?; What Effect Will the Fed Balance Sheet Reduction Have in 2019?; and, But Now It’s Not Just the US Federal Reserve Reducing its Balance Sheet. Updated again 2 April 2019 with change in timing of reductions.