We like our bankers to be credible, right? Right?

Well, RBA Governor Lowe failed the credibility test this week after a limp apology for raising rates two years earlier than he had guided. I’m not even sure why he bothered given he thinks it was only partly his fault. Nonetheless, someone scripted it.

Personally, I’d like to know if he and the Board plan to apologise for barbecuing the RBA balance sheet with a lazy $37 billion loss.

Still, this got me thinking. On the other side of the planet, what might the Fed have to apologise for, or back pedal on? What key tests lie ahead of it in the days and months to come?

And while his resolve and credibility as a warrior banker against above-target price inflation is predominantly being fought with interest rate hikes, Fed Chair Powell has promised to normalise his bloated balance sheet, half of which his Fed engineered, and which currently sits at $8.6 trillion - about 10x the size it was before Bernanke mooned it in 2008, out of experimentation and desperation.

But we may need to wait until April next year to test him on this and see whether he can pull off the first phase of liquidity withdrawal, i.e., balance sheet run-off2.0.

And why April? Read on.

Run-off1.0 came to an end in 2019

Back in 2018, the Fed (under Chair Yellen) started its balance sheet run-off in an attempt to reduce the size of its balance sheet from around $4.5 trillion to somewhere lower. The figure of $2 trillion as a place to land was mooted, but no one ever agreed on the number.

Alas, Trump couldn’t help himself, and the Yellen Fed was replaced by a Fed run by Powell in something that resembled a Greek tragedy, and together the master and her apprentice only managed to reduce their load by c.$639 billion. You can see that in the chart below.

Let’s call that failed first attempt into the unknown, run-off1.0.

Let’s also remember that before the exigent circumstances 10 years earlier that started the Fed’s buying (i.e., the GFC and Paulson’s vomiting episode) the balance sheet was only a measly $850 billion.

Back to early 2019 when Donald Trump and the market puked, Powell pivoted, run-off1.0 was whipped off auto-pilot and then terminated, and the federal funds rate (FFR) was cut to zero.

Free money returned. The Capital Asset Pricing Model stopped working. Tech and crypto mooned. The market partied (just what Trump wanted) and over the next 2.5 years we witnessed massive wealth creation from zero rates/risk assets, with COVID staking that rally in the heart for no more than a couple of months.

Then there was a quick V shaped risk asset recovery funded by COVID stimmys which produced the biggest returns we have seen in a generation, for those who bought the dip. Ahem, Mr El Arian, but maybe that’s another apology yet to come.

Back on point though, in November 2021, the exponential trajectory came to an end and since then, barring a few pockets in the supply chain squeeze trade and some EMs (emerging markets), equities and bonds in the U.S and Europe have not been a good place to be.

Next, in an effort to slay stimmy/COVID/Russia induced inflation, Powell’s Fed has been increasing the FFR, with the balance sheet normalisation, or run-off2.0 rigged for silent running just below the surface.

But the key point is that run-off1.0 was only able to wipe a limp $639 billion (or 14%) from an already bulging c.$4.5 trillion balance sheet.

So, can the Powell Fed at least match the $639 billion run-off achieved during 1.0? And if so, when will we know?

Run-off2.0

It started on 15 June 2022, with a $30 billion run-off in treasuries and a $15 billion run off in MBS (mortgage-backed securities) reinvestment.

The monthly cap of $45 billion (i.e., funds that would not be reinvested following asset maturities) was increased to $90 billion in September.

By my calculations, assuming the Fed continues as planned it could again get to a ~$639 billion asset reduction (i.e., the same quantum, but half the proportion, shaved off during 1.0) sometime in March/April 2023, so let’s call it April 2023.

This should not be a problem. I say that because of the still chill $3+ trill depositary institutions have parked up with the Fed, even though there are no longer any minimum level reserve requirements (as of 26 March 2020).

The voyage home to April 2023?

Will Powell’s Fed be able to get past the $639 billion mark this time? Will it also be able to preserve short-term liquidity through a properly functioning repo/reverse repo market, noting that by April 2023, the Fed says the FFR should be somewhere between 4.5% to 5%, if not higher?

April 2023 is likely to be a defining time for the global economy, for many reasons. Here are some:

Higher federal funds rate (FFR)
PMI expected to have cratered in the U.S. and Europe
Inflation expected to have fallen further
Unemployment expected to be rising
Corporate earnings for Q1 expected to have contracted
More COVID waves expected to have washed through economies
zero-COVID and China unrest expected to continue
Russia and Ukraine still a mess with Putin’s war on NATO’s doorstep.

Will the global economy that’s lumbering under a c.4x global debt to global GDP stack be able to handle a 4.5% to 5% FFR fuelled US dollar? Or will the Fed pivot?

Pivot it might have to, but still, the Fed’s credibility will be burnt if it fails to get the balance sheet down given the aggressive stance it has taken in fighting off the inflationary infidel and if it fails this test, the view will most likely become that the balance sheet (still over $8.6 trillion today) can’t possibly be tamed. Yikes. Realisation of the inevitable?

Whereas, if the Fed succeeds (which is extremely difficult to see) demand, consumption and households will be done like rotisserie chickens.

But does $639 billion on a near $9 trillion base really qualify as success?

Nope.

Run-off1.0 represented around 14% of the balance sheet at the time, so to emulate that same percentage this time would require a run-off of $1.2 trillion (not $639 billion) which in turn would require 6 additional months at the $90 billion cap, making the next test for the Powell Fed in or around October 2023.

After that, if that’s possible, the Fed would be left holding $7.7 trillion in assets.

And to get that down to $3.8 trillion (where Yellen’s run-off1.0 finished during Powell’s term in 2019) and remove all of the useless COVID liquidity the Fed would still have another $3.9 trillion to get rid of.

At a $90 billion monthly, it would take another 3.5 years after October 2023 to do that. 2027? Ooft, that doesn’t sound like such a great or workable idea.

Here’s to seeing whether Powell can go where no QE Infinity loving Fed has gone before - a trim and toned balance sheet with sufficient dry powder to deal with the next crisis.

Mike

April 2023 where no Fed has gone before?

We like our bankers to be credible, right? Right?

Run-off1.0 came to an end in 2019

Run-off2.0

The voyage home to April 2023?

But does $639 billion on a near $9 trillion base really qualify as success?