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The Most Dangerous Balance Sheet in the World

2 | By Shah Gilani

The Federal Reserve System, America’s private central bank, has a problem. Actually, make that two related problems:

  1. Their massively bloated balance sheet shows assets worth $4.5 trillion, and…
  2. In the Bank’s new era of “transparency” unwinding that balance sheet will disrupt markets.

The Fed has painted itself into a dangerous corner, and the smartest way to get themselves out of it is probably what they are least likely to do.

Here’s what markets can expect from Fed decisions, and how to play stock and bond markets the way insider Fed members will be instructed to play them…

How Fed Transparency Became a Market Necessity

Historically, Fed officials didn’t speak much about prospects for the economy or markets, or about their policy decisions. In fact, they don’t speak much about why they do what they do even when they were conducting open market operations.

As recently as 1987, in his testimony to Congress, then Fed Chairman Alan Greenspan explained, “Since I’ve become a central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”

That all changed with the 2008 financial crisis.

With markets in freefall, two major investment banks wiped out, and the biggest banks in America essentially insolvent, the Federal Reserve took unprecedented action.

The Fed was providing unlimited liquidity to faltering banks – including foreign banks – and agreed to let both Morgan Stanley and Goldman Sachs, two giant investment banks, become commercial banks to get access to the Fed’s Discount Window and liquidity lines. All the while, critics in Congress who blamed the Fed for creating the subprime crisis and then bailing out their bank constituents demanded transparency out of the nation’s private central bank.

The cries of “Audit the Fed!” over the Fed’s hand in abetting the crisis with their artificially low rates and  bailing out of bad actor banks wafted through Congress. Pretty soon, Fed officials (starting with Fed Chairman Ben Bernanke) began a course of greater transparency.

They had to.

Telegraphing low interest rates for the foreseeable future and announcing regularly scheduled “large scale asset purchases,” the Fed’s reference to what the rest of the world calls quantitative easing, was the Fed’s way of calming markets and letting them know they weren’t going to stop backstopping big banks, the bond market, or equities markets.

Fed transparency had become a market necessity.

But now, expected and demanded transparency is going to backfire on the Fed. It will disrupt the very same markets the Fed had used “announced transparency” to backstop and push higher and higher.

The underlying problem is the $4.5 trillion of “assets” on the Fed’s so-called balance sheet.

Those assets are U.S. Treasury bills, notes and bonds of various maturities and mortgage-backed securities… Presumably, all government-backed “agency” securities.

Fed officials have been testing the waters about moves to unwind their balance sheet since the last Federal Reserve Open Market Committee (FOMC) meeting. Recently released meeting minutes revealed that, besides interest rate deliberations, when and how to start unwinding the balance sheet is getting increasing discussion time.

According to public comments and interviews, the Fed would raise short-term interest rates one or two more times this year, then pause rate increases and, alternatively, start reducing its balance sheet. “When we decide to begin to normalize the balance sheet, we might actually decide at the same time to take a little pause in terms of raising short-term interest rates,” said New York Fed President William Dudley in an interview on Bloomberg TV last week.

How to wind down the Fed’s gigantic portfolio, as the economy moves closer to meeting the Fed’s goals of steadily low inflation and maximum sustainable employment, is increasingly becoming more important than timing further rate increases.

That’s because, if left alone, interest rates probably wouldn’t move much anyway. They could even drift lower. But if the Fed stops buying bonds and lets their balance sheet “run off”, interest rates could rise faster than expected and quickly hand bond investors big capital losses, spook the stock market, and potentially push the economy back into recession.

Play the Triggered Selloff like an Insider

The Fed’s large scale asset purchase program is over… At least, as far as adding to their balance sheet.

However, the Fed’s still purchasing bonds regularly. As those bonds the Fed’s sitting on mature (meaning they stop paying interest to the Fed and the Fed gets back the principal it spent to buy them), it’s using that principal to buy equal amounts of bonds to offset the “run off” of steadily maturing bonds.

By not buying bonds to replace maturing securities, the Fed ceases to be a steady bidder for bonds. That means market buyers have to make up the difference. If they don’t, issuers of bonds will have to raise rates to attract them. As rates start rising in the free marketplace, and not because the Fed is engineering them gently higher, they could tick a lot higher and faster than expected.

If that happens, bond holders who own trillions of dollars worth of bonds with artificially low coupons (interest rates) will start seeing capital losses on the bonds they hold. When rates rise, existing bond prices fall to levels where if they are sold, their worth (the price an investor pays and the interest rate coupon they get) is almost equal to new bonds being issued with higher rates. That’s why bond prices fall when interest rates rise.

The problem the Fed created for itself with its huge balance sheet and its new “forward guidance” transparency is how to unwind its portfolio without tanking bonds and triggering a stock market selloff at the same time.

In order to not create too much disruption, the easy way to start exiting would be to quietly buy shorter and shorter term maturity notes and bills with returned money from maturing longer term bonds.

The average maturity of the Fed’s balance sheet assets is 7 years.

As longer term bonds mature, if they, instead of replacing them with equivalent maturity bonds, bought shorter and shorter term maturity bonds, they could tell markets they are maintaining their balance sheet for the foreseeable future. Then they could unwind it as the short term paper they own matures.

Not only would markets not be able to react directly to the Fed’s unwinding plans if they weren’t announced, if there’s a lack of market disruption and the economy continues to muddle along at 1.5% to 2%, the Fed could unwind a few trillion dollars’ worth before they have even told markets what they had done.

That would be a huge boost to markets and confidence to know the Fed’s emergency powder keg was full again, and that nothing bad had happened while they unloaded their balance sheet.

But they can’t do that because of their transparency trap.

The Fed’s probably going to announce its moves. But before they tell the world what they’re going to do, they will undoubtedly tell the primary dealers that do business directly with the Fed, their insiders club.

Markets will eventually react to what the Fed’s telling primary dealers, because the primary dealers will buy and sell securities to position themselves to accommodate what the Fed’s going to do.

For example, if the Fed’s going to shorten its maturity curve and keep buying replacement securities from primary dealers, the primary dealers will start loading up on the maturity lengths the Fed will buy.

We’ll start seeing that reflected in the yield curve and we’ll know what’s happening.

I’m watching the auctions and secondary markets for volume indications of who’s buying what and how the curve is being shaped. I’ll telegraph here what I see happening.

If you have a “heads-up” on what the Fed’s doing before they announce it publicly, you can get into the right bills, notes, and bonds… and out of the ones that are being run out (like I plan to do with ETFs). We can jump out of the way of stocks that will get hit, and jump into plays that will profit from the Fed’s balance sheet moves.

Stay tuned. I’ll keep us on the inside.

Sincerely,

Shah

2 Responses to The Most Dangerous Balance Sheet in the World

  1. Robert in Vancouver says:

    If the Fed buys shorter and shorter term maturity bonds as Shah suggests, would the yield curve steepen or become inverted?

  2. Hugh in Texas says:

    The US dollar will increasing look like it will lose its status as the world’s reserve currency in the next 12 months. One would expect the Fed will hold off on deciding how to unwind its portfolio of assets.

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