Will Fed's Frankenstein return to haunt?
Abraham George Macro Musings
The Fed released the minutes of the March meeting yesterday. They have laid the foundations for reducing the Fed’s balance sheet. The Fed officials are seemingly starting to roll off $60 bln in treasuries and $35 bln in mortgage-backed securities from its balance sheet for three months starting in May. The minutes also hint at the potential for multiple 50 basis point hikes this year.
From a historical standpoint, the liquidity pull-back is about twice what the Fed did from 2017 to 2019. The 0.50% rate hike (now expected at the May 15 meeting) will be the first one since 2000.
I really wonder if the Fed has any idea of the serious impact on the real economy. When you create a ‘Frankenstein’, the monster will control you. It is all trial and error for them.
When you make money more expensive or the dollar relatively stronger, the impact will be felt in all areas of the economy. It will impact the mortgage rates, car loans, credit card rates and how Wall Street will start valuing the future cash flows and other investments.
Currently, everything is balanced to perfection and nobody has any clue regarding the rate that will not imbalance or upset the present state of affairs. With the upheavals in geopolitics (especially the heavy sanctions that are being applied on Russia), the chances of a policy error are much higher.
Finally, everything will show up in the movement of stock and bond prices. So far, the bond prices have reacted strongly but equities have been fairly muted.
What historical precedents do we have? During the GFC in 2009, the Fed’s response included three iterations of QE resulting in the Fed adding $3.5 trillion in assets to the balance sheet. Later, they tried to normalize rates and shrink the balance sheet (i.e. Quantitative Tightening or QT). From 2017 to 2019, they allowed $800 bln worth of assets to mature. Guess what? The Fed was forced to restart QE by the end of 2019.
A very strange thing happened in Sep 2019 which went fairly unnoticed by the general public as the Fed quickly acted upon it. A huge spike in the overnight lending rate took place and the Fed gave the following explanation:
“Strains in the money market in September occurred against a backdrop of a declining level of reserves, due to the Fed’s balance sheet normalization and heavy issuance of treasury securities”.
So the Fed was forced to rescue the situation because of an unforeseen consequence of balance sheet normalization. With that in mind, the Fed is allowing about 1% of the Fed’s balance sheet to roll off. This is very important. Many are expecting some aggressive QT. But the Fed surely has memories of what happened in 2019. Of all the fiscal easing that has taken place so far, 40% happened in the last 18 months since the pandemic. My belief is that the administration will be quick to pump liquidity again if they think the economy will start faltering and the markets will start to fall significantly. We are in no man’s land right now!
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Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and multi-billion dollar portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund. Currently, he is a co-founder of a new hedge fund where foreign citizens can invest in Indian growth stocks like Tanla operating in hyper-growth markets like CPaaS.