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The Fed balance sheet settles into a predictable path

| October 16, 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.

The Federal Reserve’s asset holdings have been remarkably quiet in the last three months. Its lending programs for cities and states and for small and medium businesses have seen little uptake. Demand for dollar swaps and repo has come and gone. Its securities purchases keep chugging along, but unless the Fed decides to sharply ramp up purchases of securities, there is limited scope for extra growth.

Tortoise and the hare

The story of the Fed’s balance sheet expansion in the wake of the pandemic resembles the hare in the fable The Tortoise and the Hare. From early March through early June, the balance sheet surged at an unprecedented clip, surpassing even the QE conducted after the Great Financial Crisis. The Fed bought roughly $2 trillion in securities promote market functioning. It also added close to another $1 trillion in liquidity to the domestic and global financial system, mostly in the form of dollar swaps (Exhibit 1).

Exhibit 1: Federal Reserve Balance Sheet ($ Billion)

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

Once the Fed settled in to a more sustainable pace of securities purchases, there was a widely-held view that the baton would be passed to the various lending facilities rolled out in March and April and that trillions more in liquidity would be dispensed. However, the Fed’s lending facilities have been mostly shunned by private borrowers. This is a good news/bad news story. The good news is that financial markets recovered much more robustly than most expected in the months after the March spasm of illiquidity and risk aversion. As a result, the backstop that the Fed’s programs represented proved largely unnecessary. For example, all but the riskiest government borrowers have been able to issue paper in the muni market at rates substantially lower than the Fed’s Municipal Lending Facility offers.

The bad news is that, even where the need remains acute, the terms of the Fed’s facilities are viewed as too stringent to attract borrowers. The Main Street Lending Facility was supposed to be a lifeline for small and medium-sized businesses who are unable to tap the corporate bond market. With the PPP expired, one would imagine that the need for funds would be urgent, but neither banks (lenders) nor companies (borrowers) have been eager to tap Main Street.

In any case, for better or worse, the Fed’s lending facilities have barely been used. The Primary Corporate Credit Facility, the Municipal Lending Facility, and Main Street, the three vehicles that the Fed created to infuse money directly to private borrowers, have garnered a grand total of about $4 billion in use. Moreover, Chairman Powell has signaled that the Fed has essentially thrown up its hands. He noted that officials are looking at further minor tweaks to the program, but he has admitted that, unless the economy takes a sharp step down from here, the Main Street Facility is unlikely to see much action.

There are two other broad groups of Fed assets on the balance sheet. First, there are various forms of liquidity provision, focused mainly on money markets. In the early days of the pandemic, these were heavily used. The dollar swaps program had close to half a trillion dollars outstanding at one time, as dollars were needed overseas. In addition, the Fed was offering several hundred billion in repo liquidity, supported the commercial paper market with the MMLF and the CPFF, and added help for dealers (PDCF), banks (discount window and PPPLF), and the asset-backed securities market (TALF). In all, these programs added up to almost $1 trillion at the highs. But as financial markets returned to normal functioning, demand waned, and these programs are now adding less than $100 billion combined to the Fed’s balance sheet.

The third broad category on the Fed’s balance sheet is securities holdings. The Fed bought massive amounts of Treasuries and agency MBS in March and April to support dysfunctional markets, but as liquidity was restored, the pace has scaled back to roughly $120 billion a month—$80 billion Treasuries and $40 billion in agency MBS plus reinvesting redemptions. That is still a faster pace of buying than seen during the rounds of QE in the years after the Great Financial Crisis.

In addition, the Fed bought corporate bonds in the secondary market to help support that source of liquidity for large firms. That initiative may have given the Fed it’s largest bang for the buck in history, as the announcement had a massive impact on credit spreads, going all the way out to below investment grade securities, as the Fed suggested that it would buy high-yield ETFs. As it turns out, the tightening of spreads occurred so violently and so rapidly that the Fed was able to quickly reduce its footprint. In total, the Fed has bought about $13 billion in corporate securities and ETFs since mid-May, but it has only purchased about $100 million a week since August.

Balance sheet outlook

In total, the Fed’s balance sheet as of Wednesday was essentially unchanged in size from the beginning of June at just over $7 trillion, as steady securities purchases have largely been offset by shrinking liquidity provision. Going forward, the balance sheet should begin to expand again, as the liquidity components have largely dwindled to nothing. The only notable shoe left to drop would be when PPP loans are forgiven, and the term repo offered against PPP loans is extinguished.

Unless demand for the Fed’s lending facilities suddenly ramps up, the Fed’s balance sheet should grow at a very predictable clip of around $120 billion per month, reflecting the Treasury and agency MBS purchases. With the balance sheet currently running at just over $7 trillion, that would bring the likely year-end level to almost $7.5 trillion. If the Fed were to continue buying securities at the current pace for all of 2021, the balance sheet would likely move to just below $9 trillion, which is about where primary dealers back in April thought it would grow to by the end of the recently completed quarter.

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