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A slow build for the Fed balance sheet
admin | June 12, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The Federal Reserve has rolled out an array of new programs since the beginning of the COVID crisis and resurrected several programs from the financial crisis. Most of the early interventions targeted financial market dislocations. These efforts have been very successful, in some cases without the Fed even having to follow through with significant purchases. The Fed is now moving on to a more difficult and new task: lending money directly to businesses and municipalities. Those programs have potential to grow to massive sizes if there is uptake. Growth in the Fed balance sheet so far is largely related to the Fed’s securities purchases and liquidity provision, however, not to its lending programs.
Balance Sheet Snapshot
The bulk of the expansion in the balance sheet since mid-March has come from Fed purchases of Treasuries and agency MBS (Exhibit 1). The next largest increase comes from the dollar swaps that provide dollar liquidity to overseas banks through their central banks. Meanwhile, the various lending facilities offered have generally had limited take-up.
Exhibit 1: Federal Reserve balance sheet
Note: * Figures for these categories exclude the equity capital supplied by Treasury to the Fed that backs these programs. Source: Federal Reserve.
In fact, aside from securities purchases and dollar swaps, the Fed’s balance sheet has expanded by only a few hundred billion dollars over the past three months. Moreover, several of the early programs, such as discount window lending, the Money Market Mutual Fund Liquidity Facility (MMLF), and the Primary Dealer Credit Facility (PDCF) are actually shrinking, as liquidity disruptions have largely resolved.
Meanwhile, the Fed resolved some other specific market dislocations without having to expend much money. The CPFF facility bought about $4 billion in commercial paper, mostly in late April, and has sat dormant since as commercial paper rates fell well below the rates at which the Fed offered to lend. Similarly, the investment grade corporate credit market improved dramatically with the announcement of the Fed’s primary and secondary Facilities. So far, the Fed has bought just slightly more than $5 billion in ETFs and no company bonds in the secondary market. It is difficult to imagine that many issuers will go to the Fed’s Primary Facility in light of the robust appetite of investors for new issue corporate paper and the narrowing spreads in that market.
Shifting gears
Up to now, the Fed has been in familiar territory, using its balance sheet to promote smooth market functioning. Its efforts on this front have been wildly successful, as risk spreads have narrowed dramatically since March. In fact, commentators are already beginning to talk about the possibility of asset bubbles thanks to the Fed’s accommodation.
Going forward, the Fed is venturing into new territory. The Main Street and Municipal Lending Facilities represent efforts to lend directly to business and municipalities, something that the Fed has never done before. These programs are just getting started. The MLF has executed one deal for $1.2 billion while the Main Street facility has yet to open. Media reports have suggested that neither businesses nor municipalities are excited to use the programs, as the terms are viewed as not especially attractive. In fact, the Fed has recently announced changes to both facilities in recent days in an effort to entice more borrowers.
If the facilities do generate significant interest, then the Fed balance sheet may expand rapidly in the coming months, but if the take-up is limited, then the bulk of the rise in the Fed’s assets will continue to be focused on securities purchases.
The way forward
The FOMC offered greater clarity on the path of securities purchases going forward at the June FOMC meeting. The Fed intends to buy at least a net $80 billion in Treasuries and add a net $40 billion in agency MBS each month for the foreseeable future. The Fed will be buying $120 billion per month, which would amount to around $750 billion over the balance of the year.
Meanwhile, the liquidity provision programs are likely to shrink somewhat going forward. The NY Fed announced changes to the terms of its repo operations this week that are likely to reduce usage over the next few months as the repo market has gotten back to a healthier state, while dollar swaps are going to begin maturing soon and may roll off to some degree.
If the Main Street and Muni Liquidity Facilities see limited action, then the Fed’s balance sheet may not even get to $8 trillion by the end of the year, well short of where most analysts would have imagined a few months ago. In contrast, if those two facilities see the enthusiastic response that the PPP enjoyed, then the Fed’s balance sheet could approach $8.5 or even $9 trillion by the end of 2020.
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