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The Fed loads up on securities but little else

| July 10, 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.

It started looking likely a month ago that growth in the Fed’s balance sheet would fall well short of prevailing projections. The evolution of the balance sheet since then underscores the point. The only meaningful expansion is the ongoing purchases of Treasuries and agency MBS. Most other items have contracted or held steady, and the overall size of the Fed’s balance sheet has declined. Moreover, unless the Fed tinkers with the Main Street Lending Facility to make it more attractive to banks and borrowers, there may not be much growth going forward aside from asset purchases.

Balance sheet from start to peak

The Fed balance sheet has jumped by $2.8 trillion from the launch of QE on March 11 to the peak of Fed balances on Jun 3 (Exhibit 1). The bulk of the expansion came from Fed purchases of Treasuries and agency MBS. The next largest increase reflected dollar swaps used to provide dollar liquidity to overseas banks through their central banks.

Exhibit 1: Limited growth in the Fed balance sheet outside of securities

Note: * Figures for these categories exclude the equity capital supplied by Treasury to the Fed that backs these programs. Source: Federal Reserve.

The facilities created in response to the pandemic and its fallout generally had modest usage through June 3. At that time, however, the Municipal and Main Street Lending Facilities were just getting going, and there was still at least some hope that these programs would see substantial usage.

An update

Since early June, the Fed’s balance sheet has been shrinking. Many of the programs that were created in the early days of the crisis to boost liquidity in markets have receded, as market functioning has returned to a more normal stance. Meanwhile, the Muni and Main Street facilities are not seeing much demand, and the Primary Corporate Credit Facility seems unlikely to get much interest either.

The Fed balance sheet has dropped by $244 billion since early June (Exhibit 2). The decline has been driven mainly by an unwinding of liquidity in the funding market. The NY Fed made the pricing of its repo offerings less attractive in June, reflecting the view that the market could stand on its own, and went from a major player to a last resort in the domestic repo market. In fact, as of last week, the Fed’s repo program has moved to zero take-up. Similarly, the central bank liquidity swaps outstanding has been cut by more than half over the past month, as 3-month swaps that were issued in the height of the funding crisis in March rolled off and were only partially replaced.

Exhibit 2: Federal Reserve Balance Sheet: Contraction

Note: * Figures for these categories exclude the equity capital supplied by Treasury to the Fed that backs these programs. Source: Federal Reserve.

In addition, other programs that rolled out in March to bolster liquidity, such as liberalized discount window borrowing, the PDCF, and the Money Market Mutual Fund Liquidity Facility have begun to recede noticeably. The CPFF has not had any new issuance since early May, and the CP in the program will be rolling off in a matter of weeks.

Meanwhile, the new lending programs that the Fed rolled out to support the economy more broadly are, for the most part, proving to be duds. The Fed is programmatically buying a small amount of investment grade corporate paper, but even that is now tapering down, since that market is doing quite well and does not need Fed support. The Fed had been buying about $1.7 billion per week, first in ETFs and then in individual bonds, but the head of the NY Fed markets desk publicly noted this week that the pace is likely to slow going forward and indeed, already did so in the latest week. The Muni facility did one deal with the State of Illinois and has done no more. The TALF is finally open, but there has been just $250 million done.

The program with the greatest usage at the moment is the PPP Liquidity Facility, which allows banks to repo out their PPP loans for cash. Even that program, however, declined for the first time in the latest week, and, in any case, usage should dwindle once the government begins to forgive the PPP loans.

Finally, there is the Main Street Lending Facility. A month ago, there were murmurings that the program might see surprisingly low usage, as the terms were not especially favorable. Now, we know. Only a few hundred of the 11,000 banks in the U.S. have registered to make these loans, and businesses are not very excited to tap the facility. It is too soon to write the program off entirely, and the Fed is likely at some point to tweak the terms to strengthen participation, but for now, Main Street is unlikely to be a source of notable balance sheet growth.

Balance sheet outlook

This description of the landscape allows for a more precise projection of the size of the balance sheet going forward. The FOMC locked in a $120 billion per month asset purchase pace—$80 billion in Treasuries and $40 billion plus rollovers in agency MBS—in June, which, if maintained through year-end, would add about $700 billion to the balance sheet. Corporate bond purchases could add another $10 billion to $20 billion. The only other potential major source of expansion would be Main Street Lending. Let’s say for the sake of argument that Main Street sees $100 billion in lending, which may prove generous. Meanwhile, central bank liquidity swaps and other liquidity programs, including the PPP liquidity facility, are likely to contract, perhaps by around $200 billion. That would put the Fed’s balance sheet at the end of this year at around $7.5 trillion, just a few hundred billion dollars above the June peak. To provide perspective on how much of a shift that is from earlier expectations, the April survey of Primary Dealers by the NY Fed found that the median estimate of the balance sheet size as of September 30, 2020 was close to $9 trillion.

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