Fed Balance Sheet Chart – Weekly Update: 7/4/11
An update of the Federal Reserve balance sheet chart. This chart shows the proportional holdings of various assets held by the Fed. The interpretation remains the same; that – although the Fed’s actions are dilutive for the dollar - to an increasing degree, the dollar is becoming ‘good for’ traditional central banking assets again. This change might induce a period of distress over the coming months and years, I explain this in further detail below.
Physical federal reserve notes and reserve balances (held by depository institutions) are liabilities on the Federal Reserve. Loosely speaking, each dollar note is ‘good for’ a small proportion of the Federal Reserve’s assets. Naturally then, when the Federal Reserve changes the structure of its assets and liabilities, it changes the structure of each Federal Reserve note (and reserve balance) in existence. This can have the effect of increasing or decreasing the burden of dollar liabilities in the economy.
The Structure of the Dollar over Recent Years:
As is evident from the chart above, during the years leading up to the ‘credit crunch’, the structure of the Fed’s balance sheet stayed roughly the same. That is, the Fed operated in the strict boundaries of buying and selling ‘traditional’ assets (government paper, gold etc.). In this way, the dollar remained qualitatively ‘good for’ the same kind of things. However, when the crisis hit, and conventional methods of tinkering with the dollar had been exhausted, the Federal Reserve sought to reduce the burden of dollar liabilities by changing the qualitative structure of the dollar.
In particular, the collapse of ‘socially systemic’ institutions was thought to be utterly unacceptable. These institutions found themselves owning too many mortgage-backed securities and owing too many dollars. Thus, the Federal Reserve ‘moved the goal-posts‘ – so to speak – and made dollars ‘good for’ mortgage-backed securities (see chart). Thus, those ‘socially systemic’ institutions found that they were saved from the brink of insolvency, as – all of a sudden – they owed similar stuff to what they owned. Moreover, as everyone else had assets that were ‘better’ than MBSs, they found that they were – all of a sudden – happily and comfortably solvent.
The implications of QE2: Dollars are becoming ‘good for’ traditional assets again:
As is evident from the shorter-term uptrends in ‘risk assets’ (metals, agricultural commodities, equities, junk bonds, emerging market bonds and equities, etc.), the specter of QE2 has induced the ‘risk-on’ mode in financial markets. Considering the above interpretation of the Fed’s balance sheet, can this be regarded as sustainable? My guess is that it cannot. For institutions that were previously very short dollars (via leverage) and very long ‘things’ have been stirred by the images of previous hyperinflations into purchasing ‘inflation hedges’. Thus, we have a bearish scenario looming; institutions that were under pressure with the former structure of the dollar may find the same pressure creeping up on them.
[To be sure, I can reconcile being long selected assets in the ‘inflation hedge’ universe, but I have severe misgivings with the entire stock of ‘risk assets’. The change back to the ‘traditional dollar’ may catch a lot of people off guard.]
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012