Can the Fed realistically shrink its burgeoning balance sheet in the current economic environment?

Please note carefully the chart I have created here detailing the growth in the Federal Reserve Balance Sheet in comparison to the level of the S&P 500, the broader level of the US equity markets. I should point out here that I have chosen to use the actual amount of Securities being held by the Fed as representative of its entire balance sheet since it is mainly these that we are interested in for our purposes instead of overall reserve credit. The reason for this is because all of the growth in the Fed’s balance sheet has either come from the purchase of MBS securities, Treasuries and US Agency Debt.

The first thing to note about this chart are the two points noted on the chart; where QE1 began and then when QE2 was announced and then later commenced. 

When the credit crisis erupted in the summer of 2008 and the S&P 500 began to crash, you will notice that the Fed’s Balance sheet was flatlining at a very low level for the remainder of that year and on into early 2009. It was at that point that QE 1 began in which the Fed began buying up these MBS securities (Mortgage Backed Securities) that were the derivatives behind the collapse of several major institutions and brokerage houses.

Notice that was the exact bottom in the S&P 500 index which then began a nearly uninterrupted run higher from near the 700 level to near the 1100 level in January 2010. It then moved lower but found further buying running to 1200 in April 2010 where it stalled out and fell off quite sharply surrendering nearly 200 points before it bottomed again in July 2010. If you notice just after its fall the growth in the Fed’s Balance Sheet began flatlining once again and actually began to shrink somewhat.

The reason for the plummet in the S&P 500 was the fact that the Fed’s first Quantitative Easing program was coming to an end and traders began to fear the worst as it meant the end of the liquidity injections into the banking system that the Fed had been providing. It was this liquidity which had fueled the enormous rally in US stock markets over the course of the past year.

From that April 2010 to August 2010, the stock market went basically nowhere. Traders were believing that the worst of the credit crisis fallout was behind them but they could not see any signs of strong economic growth, at least growth in sufficient size to justify taking the stock indices any higher. You might remember that it was during the time preceding the April 2010 drop in stock prices that the phrase, “green shoots” was in vogue. Those green shoots died on the vine when it appeared that QE1 was ending and there was nothing to take its place. Note once again, during this time frame the Balance Sheet of the Federal Reserve was shrinking.

Enter the Fed to the rescue of the markets once again. In September 2010 it was announced that since the economy was still encountering strong headwinds, another tool would be needed to stave off deflationary pressures and provide more liquidity to “gradually increase inflationary pressures” which would be necessary to break any deflationary mindset. Even though the QE2 program was not to be implemented until November 2010, the stock markets went giddy with delight immediately launching into another rally which took the S&P 500 past the old April high and onto new heights near 1300 where it now currently sits.

Again, you will notice that the correlation between the further expansion of the Fed’s Balance Sheet with QE2 and the upward movement of the S&P 500 is nearly exact.

The conclusion we can draw through all of this is very simple – it is the expansion of the Fed’s Balance Sheet through both QE1 and QE2 which has supplied the liquidity driving equity markets higher. Without this liquidity the economic expansion has been far too fragile to continue on its own merits. For any talk about the Fed supposedly withdrawing this liquidity one has to believe that the economic recovery is of sufficient strength to hold its own without it. Just look at what happened to the S&P 500 in April 2010 when QE 1 was drawing to a close and the economic data showed an economy going nowhere without any signs of another QE program on the way -  it plummeted 16% in 3 months time!

But even this is only a half truth. The other side of that coin is that it is one thing to not have any further liquidity injections; it is an altogether different matter to actually begin WITHDRAWING what was in place. In other words, just as the Fed has been attempting to keep interest rates artificially low and make credit cheap and plentiful (hasn’t worked by the way) any attempt to withdraw the liquidity by selling off the Treasuries they hold as a result of the QE purchases will have the opposite effect and push UP RATES beyond the short end of the curve. That will have the effect of tightening credit and slowing its growth precisely at a time in which higher energy costs as crimping both businesses and consumers. In other words, the rising crude oil price is acting as a drag on the entire economy and slowing growth which is EXACTLY THE LAST THING that this economy needs.

Can anyone seriously believe that if crude oil prices remain near current levels and gasoline subsequently stays closer to $4.00 that the Fed is going to actually attempt to shrink the size of its balance sheet by selling off Treasuries which will have the effect of lowering bank reserves and pushing up interest rates?  How does one think this will impact the moribund real estate sector which stubbornly refuses to respond to stimulus? If you think the rate of job hiring is anemic now, just wait and see what happens if interest rates start moving higher on some supposed withdrawal of liquidity.

The other last point I wish to make and is a bit unrelated to this but is relevant - The unstated purpose of the Fed’s QE2 program was to keep interest rates low to LOWER BORROWING COSTS for the US federal government. When your national debt is over $14 TRILLION and rising, when annual budget deficits are above the $ ONE TRILLION mark and the rate of economic growth is not generating sufficient tax revenues to give any hope of seriously closing these budget deficits in the immediate future, it becomes a simple exercise in math that the cost of servicing this huge sum of debt is far easier in a low interest rate environment. When you dealing with numbers of this magnitude, a measly 1% raise in rates carries enormous consequences for US borrowing costs and interest rate payments.

I am not so sure that Mr. Bernanke would long hold his current position were he to actually attempt to withdraw any liquidity by shrinking the balance sheet of the Fed. If he were foolish enough to try in the current environment, every politician in the country would take aim at him with both barrels and begin blaming their budgetary woes and any economic woes on rising interest rates. What a convenient scapegoat he would then become.

The situation is that the Fed is stuck. It cannot withdraw any liquidity without creating an entirely new set of problems that would more than likely have to be once again dealt with by adding more liquidity and repeating the cycle. Lather, Rinse, Repeat!

If this were not already enough, the Japanese are now selling US Treasuries to repatriate money back to their country for rebuilding purposes (Japanese insurance companies hold large numbers of US Treasuries which they will need to sell and convert to yen to pay claims – that is the reason for the big rally in the yen on Friday and the weakness in the Treasuries). Toss in the fact that if China were to float the yuan higher upwardly revaluing it as some US politicians are demanding – a move which they think will shrink the US trade deficit with China – and US imports of Chinese goods were to then follow such a move by shrinking, China would need to purchase less US Treasuries to sterilize a shrinking trade surplus with the US. We would then have a situation where the TWO LARGEST BUYERS OF US TREASURIES would be curtailing purchases or outright selling Treasuries at the same time that the Fed might be wanting to begin selling what is going to eventually end up being over $1.5 TRILLION IN Treasury holdings. Just who in the world is going to buy them all? Bill Gross?