US Fed’s massive stash of assets shrank for a third straight week to US$7.01tn, the smallest size since mid-May, raising concerns that Fed’s actions will not be enough to continue providing stimulus to US financial markets. We view that recent balance sheet contraction was mainly due to slackening demands for repos and central bank USD swaps, reflecting that dollar crunch is over and financial markets have stabilized. We expect Fed’s B/S will continue to ease lower and its support for financial market will fall. It does not mean that Fed is shifting its policy stance. Instead, it is transitioning from crisis management mode to long-term easing.
- Reasons of balance sheet contraction: slackening demands for repos and FX swaps. Since Mar 2020, in order to provide support for US economy reeling from COVID-19, Federal Reserve has lowered its target policy rate effectively to zero lower bound and used a full range of unconventional and inventive policy tools. Fed opened the dollar liquidity swap lines for nine additional central banks to exchange for US dollar to help lessen strains in global US dollar funding market and support credit to households and businesses. Data released on 2 Jul showed that foreign center bank liquidity swaps dropped by 50% from its peak in late May. Repurchase agreement (repos), a facility intending to provide an alternative temporary source of US dollars, also decreased further to US$61bn from its peak in mid-Mar of US$441bn, confirming reduced money market stress. Reduction of both repos and FX swaps lead to passive contraction of Fed’s balance sheet as emergency stimulus exit. Fed also downsized mortgage-backed securities by US$32bn for the week ending 2 Jul.
- Severe global dollar crunch is behind us. Reduction in the dollar swap lines and support for money market funds show that financial and credit markets are returning to near-normal. Therefore, US banks are further dialing back their use of repurchase agreements and other central banks are relying less on Fed now. The severe shortage of US dollar around the globe since Mar 2020 was almost over. Looking ahead, USD may weaken as US economic recovery is likely to lag behind many other regions and global risk appetite may continue to improve following encouraging coronavirus vaccine trials.
- Enormous liquidity has avoided financial crisis, but also pushed valuations to levels that fundamentals do not justify. Despite recent contraction, Fed’s balance sheet with the size of US$7tn is still enormous, almost double the size of Sep 2019. Central bank easing results in surging global liquidity, which helps financial markets by lifting valuations to levels that do not justify their fundamentals. However, US economic recovery still has a long way to go. Fed expected US GDP to contract 6.5% in 2020. Labor market, as we see, is not able to return to pre-virus level for quite some time.
- Liquidity environment, what to watch? Reduction of both repos and FX swaps cause passive contraction of balance sheet. As more FX swaps due to expire next week, Fed B/S contraction may continue, which is a natural exit from crisis mode. Fed actively manages balance sheet by purchase of Treasury and mortgage-backed securities (MBS), as well as other unconventional tools. Fed has reduced the pace of buying Treasury and MBS compared to it of the past three months, but Fed still pledges to continue at least at current pace, which means the liquidity condition will not be tighten over the coming months.
- 2H20 Fed policy outlook: transitioning from crisis management mode to long-term easing, from financial to non-financial. Fed is exiting from some pandemic relief measures, because the needs of emergency lending facilities, which aim to ensure the flow of credit to the financial sector, have become limited. However, we do not see shift of Fed’s policy stance. We expect that US Fed is likely to keep its ultra-easing monetary stance until the economy gets back to full employment, a process which we believe will take years. Benchmark short-term borrowing rate may stay in the range of 0-0.25% throughout 2022. Fed is expected to continue to purchase US Treasuries and agency mortgage-backed securities (AMBS) at current pace throughout 2H20. Moreover, Fed is shifting focus from large scale asset purchases to the provision of credit to the non-financial sector, so Fed will provide more help to Main Street than Wall Street in 2H20. US stock market may be very sensitive to these transitions.