After three months of unprecedented gains, which saw an increase of $3 trillion to $7.2 trillion, the Fed’s balance sheet has posted its fourth consecutive weekly decline since the start of the corona crisis according to the latest H.4.1 statement.
The drop in the week ended July 8 amounted to $88.3 billion, surpassing the steep drop recorded three week earlier, and was the biggest weekly drop since May 2009.
However, as has been the case in the past three weeks, the drop in the balance sheet was not due to a reversal or even slowdown in QE which continues almost every single day, with the Fed adding another $18.2 billion in Treasurys even as the settlement calendar and prepays meant the amount of MBS was unchanged at $1.911 trillion (don’t worry, the Fed is also buying about $4.5BN in MBS every day), but once again due to a decline in liquidity swaps, which shrank by $46.3 billion to $179.1 billion, after a $49.5 billion drop in the week prior and $77.5 billion the week before that.
The amount of outstanding repo agreements also declined for a second consecutive week by a substantial $61 billion, after a $9 billion decline in the week prior, as financial conditions are clearly starting to tighten.
As shown in the chart below, the total amount outstanding in the swap lines, designed to ease a surge in demand for U.S. currency in the participating banks’ jurisdictions during the early weeks of the crisis, was the lowest since early April.
Coupled with other indications of shrinking demand for the Fed’s bevy of emergency liquidity facilities, the reduction in currency swap line usage is for many analysts a sign that global financial markets are returning to near-normal after being upended by the coronavirus outbreak in February and March. “We expect a more rapid decline over the coming months as the majority of the swaps will roll off,” Citigroup economists wrote in a recent note.
The flipside is that it also means that the system is once again seeing a shrinkage in the circulation of the world’s reserve currency, an explicit tightening in financial conditions, and the adverse global impact of any macroshock will be substantially greater when one hits in the coming weeks.
Meanwhile, with the S&P500 closely tracking the Fed’s balance sheet in the past three months, which has served as the only factor behind the rebound in the market and the modest boost to the economy by monetizing the $3 trillion in new debt issued recently, the latest weekly drop coincides with the period of heightened volatility in the past four weeks.
The shrinkage comes at a time when the Fed’s monthly liquidity injection has been tapered to approximately $120 billion, which suggests that while the balance sheet is likely to resume growing in the next week, it will be at a more gradual pace.
It also means that for the stock market to move substantially from this point on – since the market is now fully disconnected from fundamentals and is simply a derivative of endogenous liquidity and fund flow – Powell will need to find another justification to expand the Fed’s QE aggressively, as discussed in “JPMorgan Spots A Big Problem For Stocks.” Something like – for example – a second wave of the coronavirus pandemic…
Finally, those keeping track of how much corporate bonds the Fed has bought, the latest total for the Fed’s Corporate Credit Facilities LLC which includes purchases of both ETFs and corporate bonds, the Fed disclosed that as of July 8, there was $10.4 billion in book value of holdings (the Fed does not break out how many actual bonds it has bought vs ETFs), an increase of $754 million from the $9.7 billion a week prior. Which means that the Fed is now buying around $150MM in corporate bonds and/or ETFs every single day, a sharp drop from the roughly $300MM/week it was buying just one month ago.