Perhaps the fluctuations in precious metals and cryptocurrencies are merely a side dish? While gold, silver, and Bitcoin have indeed experienced sharp volatility recently, with significant pullbacks in certain periods, there currently appears to be no evidence of a major dislocation in the markets. The S&P 500 did decline on Tuesday, but it closed significantly off its lows. By some metrics, retail buying remains robust, which is not indicative of broad-based financial stress.
Looking further ahead, bond traders may need to consider how to deal with a potential future Fed Chair who desires to cut interest rates (a positive!) while also aiming to reduce the Fed's duration exposure by shrinking its balance sheet. However, concerns about the latter might be overblown. Aside from the procedural hurdles of forcing through a policy that balance sheet experts like Lorie Logan might not agree with, the sheer size of the central bank's balance sheet may not be entirely within the Fed's control, provided the demand for its liabilities remains strong.
One of the strangest occurrences I've witnessed in my career was a 27% rebound in silver over two days that looked like just a correction. Only time will tell if silver can defy the odds and reach new highs in the coming weeks or months. But the charts might offer a clue: compared to the preceding decline, the surge from Monday's low has been relatively modest, and this overlapping price action is often characteristic of a correction. At the time of writing, gold had recovered most of its recent losses, but the rally stalled at the 38.2% Fibonacci retracement level.
The performance of cryptocurrencies suggests that popular speculative vehicles are not yet out of the woods. Although Tuesday's stock market decline had some spillover effects, I've heard anecdotal reports of strong retail buying, with Barclays' "Retail Favorite Basket" index rising nearly 1.4% yesterday. While a similar index from Goldman Sachs also dipped slightly, its decline was far less severe than that of the S&P 500.
On the whole, the retail crowd appears to be attempting a posture of calm composure, although further declines in Bitcoin and continued softness in metal prices could test their resolve. The market has recently seen numerous "forced connection" narratives, with some observers attempting to blame the decline in metals and other risk assets on Trump's nomination of Kevin Warsh. This argument is weak on several levels: a) Cryptocurrencies have been falling for four months; b) Gold plummeted around $400 in about 90 minutes last Thursday morning, well before Trump announced Warsh's nomination; c) If the market were betting on Warsh being a hawk, why did the yield curve steepen immediately?
While Warsh might be a dove on interest rates (at least, that's the view he reportedly expressed to Trump), he is a hawk on the balance sheet. His idea is to get the Fed out of the way of Wall Street (and presumably the real economy) by reducing the distortions caused by its asset holdings. This can be achieved in two ways: altering the composition of the balance sheet, or simply reducing its size.
Of these two, altering the composition is the most feasible, both procedurally and practically. I mean, Warsh might be able to persuade the committee to agree to shorten the maturity of the assets it holds, a preference that Christopher Waller has already expressed strongly.
The desire to reduce the size of the balance sheet, however, is another matter entirely. Even if Warsh managed to convince the rest of the committee (which I am skeptical about), he might still find it an uphill battle. Although the Fed sets size targets during QE/ QT periods, during balance sheet runoff, it is constrained by the demand for its liabilities. These liabilities include currency in circulation, the Treasury General Account (TGA), and, of course, bank reserves. The TGA balance is projected to contract slightly from current levels but remain generally high. Reserve demand, partly (though not entirely) subject to regulatory requirements, is unlikely to decline substantially from current levels before the rules change—a point underscored by the increased volatility in funding spreads late last year.
The conclusion is this: if the Fed decides to reduce its securities holdings while reserve demand remains constant, the Fed would simply replace Treasuries and agency debt with other assets, most likely usage of the repo facility. In other words, if the Fed cuts its bond holdings to a degree that causes a cash/liquidity shortage, banks would tap the Standing Repo Facility (SRF); this amount would then sit on the balance sheet as an asset, keeping its overall size largely unchanged.
As for whether this act of swapping Treasury holdings for the role of "lender of modest resort" to the banking system truly counts as getting the Fed "out of the way," that's a question for the reader to judge. From a flow-of-funds perspective, it ultimately means the Fed sells bonds to the public and then lends to banks so they can buy those bonds, accepting the same securities as collateral for the loan. If that sounds a bit like running in circles to you, well, I wouldn't necessarily disagree. At the very least, on Warsh's first day, someone should gift him a Rolling Stones greatest hits album and cue up the track "You Can't Always Get What You Want."
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