In recent days, it's being reported that the Fed is structuring a new securities reverse repo program with Wall Street traders, in the first practical sign of a policy 'exit strategy'. At some point soon, the Fed will be buying new securities by borrowing money from the dealers rather than simply 'printing' fresh dollars as electronic accounting entries. The Fed will place its securities with the dealers as collateral when it borrows (although it may borrow against the existing securities as well). This will neutralize the liquidity impact of further security purchases ie tighten policy without hiking official rates. It's almost Chinese in its subtlety, but reflects serious misgivings among some voting Fed members about the risks of current loose policy if a recovery proves surprisingly robust in the near-term.
The Fed balance sheet has flatlined at around $2trn in recent months, despite hundreds of billions in ongoing large-scale asset purchases in the Treasury and corporate bond markets. In fact, the Fed now holds $1trn more in financial securities than it did in February, and in total has amassed the equivalent of over 10% of US GDP. However, much of the emergency liquidity facilities put in place last Autumn, both in terms of liquidity provided to US commercial banks, and to foreign counterparties via dollar swaps, have seen reduced demand (the blue line in the first chart). While the TALF program targetting car loans and credit card receivables continues to expand, it's a very small proportion of the overall balance sheet.
Additionally, as can be seen from the nicely symmetrical chart below, the Fed's purchases this year of assets from corporate bonds to Treasuries via its Quantitative Easing program, have been offset by the deleveraging of commercial banks. Bank borrowing from the Fed has collapsed from $1.7trn in March to barely $500bn now, offsetting the quantitative easing impact and restraining money velcoity and hence near-term CPI inflation risks.
The Fed will at some point be a seller of $1.2trn of securities, as it seeks to 'normalize' its balance sheet, but will seek to delay that process as long as possible to ensure recovery is sustainable and spare capacity, as indicated by industrial utilization if not unemployment, has narrowed. Many markets have been artificially boosted this year by central bank buying, most directly US and UK government bonds and investment grade corporate bonds, but many others indirectly via a 'displacement' effect as the liquidity generated in quantitative easing operations ripples across asset classes. Rate hikes in the UK and US are still probably a year away, but liquidity will be gradually withdrawn in advance of that event to test the patient's resilience. When central banks start unplugging the monetary life-support machine from global markets in a few months time (starting in Asia/Australasia), investors would be wise to retreat to the sidelines, because despite positive vital signs, a relapse is very possible given the persistence of underlying imbalances.
