Another Rare Sighting: The Fed’s balance sheet contracts over the week

It may seem a little suspect to use the words ‘another’ and ‘rare’ together as has been done in the title. After all, if one is using the adjective ‘another’, shouldn’t one be questioning the supposed rarity of the object to which it refers? Well, there is a point to this; so if the immediate trends in the Fed’s balance sheet continue, we will probably have to stop using such phrases. The reason why it’s ok for now is because there have only been four weeks in 2011 (including this one) in which the Fed’s balance sheet contracted. Here, I present several charts relating to the Fed’s balance sheet and consider the investment implications of the recent stagnation in the total balance sheet size.

 

Federal Reserve Balance Sheet Chart - ASSETS

Assets of the Federal Reserve - Click to enlarge. Source: Federal Reserve

 

Federal Reserve Balance Sheet Chart - ASSETS (PROPORTIONAL)

Assets of the Federal Reserve presented on a proportional basis. - Click to enlarge. Source: Federal Reserve

 

As can be seen on the charts above, the Fed’s assets have expanded largely in favor of US government notes and bonds in recent months (with QE2). This week, the total size of the Fed’s balance sheet contracted by around $14.5 billion. Of course, the cosy relationship between the Federal Reserve and the US Treasury remained in place as the Fed’s holdings of US government notes and bonds expanded nevertheless. The contraction came from reductions in the holdings of Federal Agency debt securities, Mortgage-backed securities, and the other junk that was picked up in 2008/2009 (e.g. the carcasses of AIG and ‘other assets’). Interestingly, the Fed opened up it’s foreign exchange liquidity swap lines this week. Zero Hedge reported:

 

The FRBNY has just announced that in the week ended August 17, it lent out $200 million to not the ECB, not the BOE, but the “most stable” of all banks: the SNB. This is the first use of the Fed’s Swap Lines since March, and the most transacted under this “last ditch global bailout swap line” (see more on how the Fed bailed out the world using swap lines here) since October 2010.

 

Taking a look at a chart of the Federal Reserve’s ‘Central bank liquidity swaps’, indeed, we find that this was the most transacted since October 2010. This particular ‘extension of liquidity’ cannot be seen on the first chart below (which uses a nominal scale) but can be seen on the second chart (which uses a logarithmic scale). This is a testament to the sheer size of the somewhat more convoluted bailout implemented by the Fed in 2008/2009!. Although this datapoint is tiny when compared to the past few years, it shouldn’t be discarded as it could be a signal that more of the same is around the corner:

 

Federal Reserve Central Bank Liquidity Line

Federal Reserve's 'Central bank liquidity swaps' - Click to enlarge. Source: Federal Reserve

 

Federal Reserve Central Bank Liquidity Line (Logarithmic Scale)

Federal Reserve's 'Central bank liquidity swaps' on a logarithmic scale - Click to enlarge. Source: Federal Reserve

 

Moving onto the Fed’s liabilities, we note that the majority of last week’s contraction came from a reduction in ‘Other’ deposits (which isn’t much use to us!) and that ‘other deposits held at depository institutions’ increased to somewhat offset the overall decrease.

 

Federal Reserve Balance Sheet Chart - LIABILITIES

Liabilities of the Federal Reserve - Click to enlarge. Source: Federal Reserve

 

Federal Reserve Balance Sheet Chart - LIABILITIES (PROPORTIONAL)

Liabilities of the Federal Reserve presented on a proportional basis - Click to enlarge. Source: Federal Reserve

 

Thoughts on the above:

 

Our thoughts on the investment implications of the above remain by and large the same; we believe that there is a disconnect between the market’s perception of the Federal Reserve, and the Federal Reserve itself. Marc Faber hit the nail on the head earlier this month (paraphrasing);

 

The Fed is probably underestimating the severity of the coming economic downturn.

 

We would add that the entire public sector is probably underestimating the severity of the coming slowdown. As we have reiterated over the past few months; the US Treasury and the Fed have been unwinding many of the ‘extraordinary measures’ implemented during 2008/2009. We wrote the following in early June:

 

After having supposedly ‘saved us from disaster’, I suspect that the fiscal and monetary authorities thought it was prudent to undo some of the emergency measures implemented during 2008 and 2009. To name a few examples of this ‘clean-up’ operation that pertain to the ‘QE2′ period:

 

  1. The Federal Reserve reduced its holdings of Federal Agency Debt Securities.
  2. The Federal Reserve reduced its holdings of Mortgage-backed Securities.
  3. The Federal Reserve unwound some of its loan facilities.
  4. The Federal Reserve reduced its holdings of the range of LLC’s made from the carcasses of AIG etc.

 

Moreover, the US Treasury have also taken part in this clean-up operation by (at least):

 

  1. Unwinding the supplementary financing account program.
  2. Unwinding its holdings of Mortgage-backed Securities.

 

To their merit, the fiscal and monetary authorities seem to be at least trying to do as they said. After all, these measures were supposed to be temporary. The only thing is that if they actually realized what they were (and are) doing, they would probably not do it!

 

Meanwhile, looking at the gold and bond markets, it would seem that the market is discounting large and imminent monetary debasement. Our contention is that either the monetary authorities need to accommodate the market’s perception of it (in which case, I hope you have a sizeable holding of gold!), or the market needs to reduce the degree to which it is discounting monetary debauchery by the monetary authorities (if only for a few weeks or months). Our hunch is that the monetary authorities will ‘do what the book says’ and wait for consumer prices to slow significantly before doing that which they know best (printing money). Our contention has remained that we doubt that the market will be able to sustain this level of revulsion for the Federal Reserve Note all the way up until the monetary authorities finally decide to do it. This is our shorter-term bull case for the dollar.

 

[All this being said, our readers should note that this intellectual conceit is yet to be confirmed by movements in the currency markets. The dollar has been trading in a fairly tight range over recent months.

 

Dollar Index Futures

Dollar Index Futures - Click to enlarge. Source: FINVIZ.com

 

Euro priced in dollars

Euro priced in dollars - Click to enlarge. Source: FINVIZ.com

]

See here for our collection of rare historical economic data.

Posted Aug 20, 2011