To The Moon

Fed’s tightening monetary policy includes not only raising interest rates, but also shrinking its balance sheet, which has reduced by $626 billion since its peak in Apr 2022, mainly Treasury bonds and mortgage-backed securities. This could also affect market liquidity and change the yield curve to some extent.

Interestingly, after last week’s “banking liquidity crisis”, the Fed restarted its Banking Term Funding Program (BFTP) to provide short-term liquidity support for banks. After announcing the changes in each item of its balance sheet as of March 15, investors easily noticed the sudden expansion of its balance sheet.

Why did the Fed expand its balance sheet again?

Fed has three ways to expansionary: 1. Open market operations (OMO), 2. Discount window, 3. Unconventional purchases of financial assets, such as QE.

When the pandemic broke out in early 2020, the Fed quickly cut interest rates, launched massive QE, and rolled out more than 10 liquidity facilities (LF) for money-market funds, commercial paper, primary dealers and others through emergency meetings. These actions abruptly inflated the Fed’s balance sheet.

This time, the Fed’s balance sheet expansion belongs to Discount window. The Fed provides liquidity support to financial institutions as a lender of last resort when they face liquidity crises. Although primary credit increased by $14.83 billion last week, surpassing the levels of both the 2008 subprime crisis and the 2020 pandemic, primary credit is a lending tool that the Fed offers to deposit institutions with good financial conditions for up to 90 days with possible extensions. This funding mainly targets $SVB Financial Group(SIVB)$ $First Republic Bank(FRC)$ , $Signature Bank(SBNY)$ and others.

Will Fed’s Balance Sheet Keep Expanding?

As inflation remains high in the U.S., the Federal Reserve is unlikely to cut interest rates soon, which means that the mismatch between short-term and long-term assets and liabilities that has built up in the banking sector under low rates will be hard to resolve in the near term.

In particular, some smaller and regional banks may face the challenge of “deposit flight”, as savers move their money from smaller banks to larger ones, creating liquidity pressure for the former. This means that more depository institutions may need to access liquidity through the discount window, which could prompt the Fed to keep expanding its balance sheet.

The discount window is a voluntary facility that depository institutions can apply for when they face liquidity shocks. The larger the amount of discount window borrowing, the more depository institutions are under liquidity stress. Since the Fed does not immediately disclose the names of discount window borrowers, there is an information asymmetry problem in the market, as investors do not know which banks have liquidity risks. This could exacerbate anxiety and dampen risk appetite. This is fundamentally different from quantitative easing (QE), where the Fed actively buys financial assets to stimulate economic growth and boost risk appetite.

What is the effect of this expansion?

The positive effect of this expansion is to improve liquidity in the short term, but it is unlikely to change the trend of credit tightening and economic “stagflation” in the U.S. in the medium term. The Fed’s discount window can only solve short-term liquidity problems, not the fundamental mismatch of maturities among U.S. banks. As the Fed finds it hard to cut interest rates in the short term, banks will tighten credit voluntarily to reduce their own risks, which will increase the downward pressure on the real economy. Corporate profits will slide further, and the ultimate result may be a “stagflationary” recession for the U.S. economy. History shows that stocks and bonds perform poorly under stagflation, U.S. bond yields may fluctuate at high levels, and U.S. stocks may continue to “grind lower”. Therefore, in the medium and long term, expansion may have a negative impact on the economy.

At the same time, investors should also see differences,

• The Fed continues to reduce its holdings of Treasurys and MBSs, indicating that balance-sheet runoff is still ongoing;
• QE is when the Fed directly buys and holds assets while controlling liquidity in secondary markets; whereas discount window and BTFP are both short-term loans that provide liquidity to financial institutions rather than direct asset purchases by the Fed.

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