Friday, March 27, 2009

Fed's Balance Sheet Expands

The size of the Fed's balance sheet peaked in December at $2.253 trillion in the week ended Dec. 17, 2008, falling to as low as $1.83 trillion in the week ended Feb. 11 before creeping up again to about $1.90 trillion in recent weeks. Then, in the week ended March 18, the Fed expanded its balance sheet by about $170 billion to $2.041 trillion, its highest in about two months.

In the latest week, ended March 25, the Fed's balance sheet expanded again, by $9 billion to $2.050 trillion. It is interesting to note that equities peaked at around the time the Fed's balance sheet did and began recovering when the Fed's balance sheet expanded. Monetarists will feast on the pattern.

The increase in the size of the Fed's balance sheet is likely to continue in the weeks and months to come, probably to at least $3.5 trillion as a result of securities purchases and eventually to over $4 trillion because of the Term Asset-Backed Securities Lending Facility.

It could eventually expand to over $5 trillion if the Private-Public Investment Fund gets off the ground and is effective. The Fed has thus far purchased $236 billion of mortgage-backed securities, leaving $1 trillion to go to meet the Fed's announced target. The Fed has also purchased $50 billion of agency securities out of $200 billion announced. The Fed will also be purchasing up to $300 billion of Treasury securities. he importance of the upcoming expansion in the Fed's balance sheet will be many-fold:

1. Eventually the Fed will find the "magic number" with respect to the amount of bank reserves that would compel banks to lend enough to promote normal levels of economic activity. The Fed found the "magic number" for some of its facilities, in particular the Term Auction Facility, the Commercial Paper Funding Facility and the currency-swap facility.

2. The Fed will revive the asset-backed securities market, and money will be channeled to consumers and businesses, boosting aggregate demand. A trough will be put underneath a swath of prominent economic statistics. For example, a bottoming in car sales will significantly affect the factory-laden economic calendar, leading to a trough in data such as durable-goods orders, factory orders, regional purchasing managers' indices, the ISM index and industrial production.

3. The purchase of agency and agency mortgage-backed securities will lower mortgage rates and do so at a time when millions of homeowners are likely to refinance their mortgages via the Obama adminstration's $75 billion Making Homes Affordable program. This will reduce the level of foreclosures.

4. By encouraging mortgage refinancing, mortgage originations will increase, boosting bank revenue in this area.

5. The purchase of Treasury, agency and mortgage securities boosts bank balance sheets. Commercial banks held $2.67 trillion of securities in early March, accounting for 22% of assets. The sharp price appreciation in the securities the Fed is targeting boosted bank assets.

6. The removal of risky securities from bank balance sheets will reduce the need to hold reserves against losses, boosting the velocity of money and unleashing some of the close to $1 trillion that banks are holding in reserves.

In the latest week, the main force behind the expansion in Fed credit was the Fed's $10.47 billion purchase of mortgage-backed securities. Agency purchases were $3.3 billion. The Fed is moving deliberately, seeking the maximum impact possible on the mortgage realm. In reality, the Fed has unlimited firepower for asset purchases, because it has a printing press, or at least the modern-day version of it.

Targeted assets are worthy investments in the current environment. In Treasuries, focus on two-years through 10s and TIPS. If the Fed's efforts bear fruit (for example, if the TALF revives the asset-backed market and the PPIP removes assets from bank balance sheets), expect investors to move a layer out the risk spectrum.

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