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posted on 02 August 2017

How The Fed Could Unwind Its Balance Sheet

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I have a theory on balance sheet normalization. What if the way to unwind the FEDs balance sheet is to buy global stock market ETFs with the interest they receive on the bonds they hold?

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During the QE experiments the interest was reinvested in debt securities that the FED had targeted to buy. The new interest strategy would be coupled with a policy of no longer rolling over expiring maturities. The money (interest and money from maturing bonds) would flow into ETFs.

As a caveat, this may be illegal and the FED would have to deny, lie and hide their actions unless authorizing legislation was enacted.

The FEDs balance sheet is $4.5 trillion US. Global market cap is $69 trillion US. Imagine they decided to take the balance sheet to $1.5 trillion US. This would require buying 4.5% of the global equity markets.

The FED’s balance sheet consists of assets and liabilities, just like any other bank, mostly. The big difference is they can create their liabilities in cash by expanding the money supply so cash can sit on both sides of the ledger. The FED balance sheet expanded after the 2008-09 crisis by increasing the money supply to purchase debt securities. The mechanism for creating money is the Treasury sells bonds to the FED and the FED transfers the cash to the Treasury. Of course I have simplified the process for this post but that is essentially how it happens. (Econintersect note: There is the intermediate step of "laundering" the transactions through the primary dealers.)

The FED was able to buy debt securities near the lows, but due to the nature of how debt instruments work, if you hold to maturity you are limited on your capital gain. So while these assets appreciated in value, the appreciation has a limitation. Plus, the interest paid becomes a FED liability. If the FED were to begin buying stocks, and they would have to be quiet about it (and it is probably illegal) this buying could create a global stock market boom. As equity prices rally from the injected capital the FED would end up with capital gains.

The FED buying stocks would actually shrink the balance sheet if stocks appreciate faster than money supply growth, as the assets held are worth more than the book value. If the FED bought $3 trillion in global stocks and they appreciated 50%, the FED would end up with $4.5 trillion US in equity assets and a total balance sheet of $6 trillion.

At this point there is two questions you should ask.

  1. Now I said the balance sheet would be shrinking didn’t I? But $6 trillion is greater than $4.5 trillion.
  2. Doesn’t this just create a new problem?

Answer to 1. is yes because at first it expands the balance sheet, but since the FED is not a hedge fund and not mandated to maximize investment returns they would be sellers more quickly than the average investor. As the FED exited stock positions, they would decrease assets (equities) and end up with liabilities (cash) on the balance sheet.

The answer to 2. is also yes, but since the FED would not be selling bonds to buy equities but letting bonds mature this process would be slow and create a longer rally. Maybe this is done over a period of 5 years and this extends the current equity market rally. This rally has been a much hated bear market, each correction has had the pundits predict the next bear. Retail and pension investors are underweight equities. As the market rallied these investors would end up chasing equity valuations higher. They would become the likely buyers.

During the final days of the Bush Administration and throughout the Obama Administration the Federal Debt in the US increased by about $8 trillion. The cash received from exiting the equity positions would then be used to purchase debt and retire it.

And there you go, balance sheet normalization. However, it is likely that after the FED removed its guiding hand equity markets could peak and retail and pension investors would suffer losses and create a new crisis, but why worry about tomorrow when you can think about today?

Now who would be the perfect FED Chair to pull off such a move? Could it be an ex-Goldman trader in the Trump administration?

This article was adapted from a post at Economisms 27 July 2017.


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