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What is the Federal Reserve’s Balance Sheet Telling Us?

I have continued to monitor the balance sheet of the Federal Reserve. You’ll see in the chart below that the light green area represents mortgage-backed securities. In the most recent quantitative easing program the Fed has decided to buy up to $40 billion of mortgages each month and the program is perpetual at this point in time. When looking at what’s been going on since the beginning of this year we actually see a moderate contraction of the Federal Reserve’s balance sheet. Even in the most recent weeks after QE3 was announced we are still seeing a moderate contraction.

This suggests to me that deflationary pressures are continuing to grow and draw down the value. This is somewhat of an ominous sign as it appears that the reflation trade is not getting traction. This could lead to the recent declines in the markets and the lack of assets expanding. While the Federal Reserve actions suggest they are trying to reflate the markets the opposite is occurring. This suggests to me that we could see further actions occur by the Federal Reserve to maintain their overall strategy of reflating the markets.

At the initial glance it appears that this balance sheet is negative and in real terms it is. However, if the Fed is committed to the reflation trade, then it will be necessary for them to step in and do additional simulative purchases beyond what was announced last month to get the balance sheet to grow again.

The chart below shows from December 2010 through May 2011 the balance sheet expanded from 2.2 trillion to 2.85 trillion. During the concerted effort of central banks around the planet last October we did see a minor spike up to $3 trillion. Since that point the balance sheet has flattened off and has actually declined back to the 2.85 trillion mark. I am positive that the federal reserve is keeping a close eye on this and is likely to come up with some further stimulus program in next month’s Federal Reserve meeting.  Should this trend continue, with no action from the fed in November, it will suggest higher probability for further action in December.

This in my opinion sets the tone for yet another stimulus related rally in the stock market. There has been a major combat made by all of the major central banks in keeping the reflation trade on. At this stage there is no way they can abort the strategy as it will cause a massive loss of confidence in the overall system. For them not to continue this trade could signal a major deflationary period and therefore a major depression.

It appears to me that the likelihood of them not following through with their commitments is close to nil as they have now put us all at so much risk that they have to continue the trade.

Back in the days of my market making activity on the Pacific options exchange I used to talk about the Incredible Growing Trade. These trades always grew out of control as the days and weeks would unfold because you had no choice but to continue to add to the trade to hedge the risk that would grow inside of the strategy. You would continue to add to the strategy until you ran out of capital. At this point there was only one action; start to liquidate the position. The result of this action usually represented a losing trade because it was more of a liquidation of a strategy that had grown out of control than a profit taking exercise.

I believe the Federal Reserve has found itself in a similar position.

 In the case of the Federal Reserve, there is no way to get out of the trade as they are making at least a 10 to 15 year commitment by buying mortgages and putting them on the balance sheets. The reason why they are stuck with these assets on their balance sheets as there is currently there are no takers willing to purchase these mortgages. With well over $1 trillion of mortgages on the balance sheet; with current market conditions it will be nearly impossible to find a market to move these off the balance sheet.

You can clearly see that from before the Bear Stearns debacle/ the beginning of the ‘08 crisis that the balance sheet was well below $1 trillion. It has nearly tripled. If you look at the assets that make up the balance sheet you will see that most of these have no choice but to be held for the long term based on what they are.

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In my opinion, these longer-term assets held in the balance sheet appear to have no liquid market to sell into. This will perpetuate slow growth and keep a large amount of risk on the economy for at least 10 the 15 more years.

From my viewpoint, it appears that it will be fairly easy to determine how the next one to three years will play out based upon whether or not the Fed is willing to step in further into this trade and demonstrate that they are willing to expand the balance sheet to 3.5 trillion or more.

I believe this is why Bernanke has continued to warn about the potential risk with the fiscal cliff issue that is coming on January 1st. His commitment to the strategy as clearly illustrated in this chart is going to keep this strategy in place. Regardless of who runs the Federal Reserve in the future, he will have no choice but to continue on the same path as there is no exit.

At this time it is impossible for us to determine on the long-term basis whether the strategy plays out positive or negative, but the current portfolio will certainly control Federal Reserve policy for many years to come.

The only hope is that somehow the housing market comes back and that their risk in the mortgage portfolio decreases enough that the institutional investors want to own this paper. If that occurs then there is an exit strategy. However, based on what we know today and the evolution of new federal regulations that will control the purchases of these mortgages as a result of the Dodd-Frank bill and other regulations that are in place, it will make it difficult for the investment community to take this paper off the Fed’s hands.

Of course the beauty is that if you have a legislature and a printing press, you ultimately can do anything you want. For now it appears that the strategy will stay in place. It is likely to keep a general positive trend in most underlying assets including stocks, commodities, and housing for the next several quarters so long as they are will to keep up the growing commitment to the incredible growing trade.

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