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Recall that our Federal Reserve is trying to normalize their balance sheet, at the same time as moving interest rates up from the artificially suppressed levels of the last decade. Both the creation of new money, here as well as around the world, as well as the unprecedented low borrowing rates have supported the economic recovery, tepid though it has been, since the great recession of ’08-’09.

Part of this Fed process is the sale (or lack of re-investment) by the  Fed, presumably on a programmed basis, of the accumulated treasury securities and other fixed income assets that were purchased as the Fed balance sheet increased by about $4 Trillion over the last decade. The reduction plan, announced in September ’17 called for $10B per month in Q4’17, $20B per month in Q1’18, $30B per month in Q2’18, $40B per month in Q3’18, $50B per month in Q4’18. That’s as far as the projected program went, for the time being. The problem is: virtually at the same time that the program started, interest rates started upward, as shown by the chart of the two year treasury note below.

The following chart shows the combined balance sheets of the six major central banks. Notice that the Fed balance sheet has been constant over the last several years, but every other major bank has inflated their assets, contributing to the worldwide monetary stimulus that has supported the worldwide economic recovery, such as it is.  It is important to know that, though most of the others continue to build assets, the European Common Bank, in particular, representing collectively the second largest worldwide economy,  has  discussed following our lead in terms of reduction, hopefully on a six month to a year lagging basis. The Bank of Japan is reducing purchases, China is trying to gracefully reduce their stimulative policies (including credit creation), and the Swiss National Bank is too small to matter. Overall, no major Central Bank is talking about expansion of balance sheet, all hoping for the opportunity to reduce, but, as the saying goes: “Hope is not a strategy.”> The question posed at the moment is whether the worldwide economy can tolerate our Fed’s reduction, let alone the others, at whatever point they come into play.

The following table shows the comparison between the presumably programmed reduction in the US Fed’s balance sheet, compared to the actual monthly performance. You can see that at know point has the reduction been “ahead” of schedule. The Fed has gotten behind, almost caught up, then most recently fallen behind by $31 B, when the cumulative reduction should have been almost $90B by now.  The next couple of weeks will be interesting, in and of itself, to see if the Fed tries to catch up with the monthly purchase plan. It doesn’t get any easier on April 1.

A short two weeks from now,  the rubber meets the road when the reduction is supposed to be $30B per month. Keep in mind that while the Fed will be trying to reduce by $30B per month (some of it by allowing maturing securities to roll off, without re-investing), our current deficit, which must be borrowed, is running at about $1T, annualized, and the treasury is re-issuing well over $1T, annualized, of existing short term debt that is maturing (without the Fed, who has been the biggest buyer in the past). All of this provides a daunting amount of supply to the fixed income capital markets, and the real possibility that interest rates will continue to rise substantially as a result. Should that happen, the US economy would be weakened, even to the extent of a recession.

It seems to us that the normalization process could come to a premature end, as the Fed aborts the asset sales and potentially adjusts the plan to raise interest rates further. Since each stimulus “hit” must be bigger than the last, to keep the economy moving ahead, in essence to maintain the “financial heroin high”, it will be interesting to see what’s required the next time around, and what form it will take.

Roger Lipton


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