US$8 trillion and counting

THE size of the United States Federal Reserve (Fed) balance sheet is back on the radar of investors as it recently hit a new milestone – the US$8 trillion (RM33 trillion) mark.

Since the start of the pandemic in early March 2020, the Fed has been instrumental in not only providing liquidity to the market, but as a backstop for debt papers that are traded in the market.

As can be seen from Chart 1, the US Fed balance sheet has risen from US$4.16 trillion (RM17.056 trillion) as at end of February 2020 to US$8.20 trillion (RM33.62 trillion) as at July 13, 2021, translating to an increase of US$4.04 trillion or nearly double in just 16½ months period. The increase in the size of the Fed’s balance sheet, which is now at about 36% of the country’s nominal gross domestic product (GDP), is worrying, as it raised concerns as to when will the Fed stop expanding its balance sheet and the impact of its policy on markets and asset prices.

As it is, the Fed has maintained its stance that it will continue to execute its bond purchase program in the market with the monthly purchase of US$120bil a month. While the minutes of the June 2021 Federal Open Market Committee (FOMC) meeting showed that members did discuss the notion of “tapering” the monthly asset purchase programme, there is still no clear reason for the Fed to act on it just yet.

Two key targets that the Fed is keeping an eye on are giving them mixed signals and hence the indecisive nature of Fed’s assessment of what needs to be done and when to execute its plan.

For the Fed, their key economic data points are the rate of inflation and level of unemployment. For the market, the concern is the Fed’s expected tapering move and the Fed Fund Rate.

US Fed balance sheetUS Fed balance sheet

The market was given a glimpse of the Fed’s assessment on this matter on Wednesday when comments made by Jerome Powell to the House Financial Services Committee saw investors taking a positive view on financial markets.

The Fed’s opinion that is too soon to scale back the central bank’s aggressive support for the US economy, while acknowledging that inflation has risen faster than expected, was enough for markets to consider that the much talked about tapering still has a relatively long runway.

Powell also stressed that while officials expect high inflation to be temporary, they would react if inflation turned out to be persistently and materially above their 2% target.

Inflation pressure has not eased off

The recent pullback in commodity prices has seen investors taking bets off the table in terms of inflation expectations with both the five year and 10-year inflation breakeven rates easing by as much as 35-40bps from recent peaks.

Nevertheless, this too has reversed again and has since climbed back up by about 10-20bps. Both the five-year and 10-year breakeven inflation rate was last seen at 2.53% and 2.32% respectively.

As the 10yr benchmark papers have rallied, yield has dropped to 1.31%, a level last seen in February this year. Even real returns on the 10-year papers, which was last seen at -1.01%, is back to the level it was in February this year.

This week, key headline inflation and core inflation data showed that inflation remains a threat as the June numbers rose by 5.4% y-o-y and 4.5% y-o-y respectively.

Based on the historical spread between core inflation and core Personal Consumption Expenditure (PCE) of about 30bps, it is likely that core PCE will register a reading of well above 4% for June.

In effect, the Fed’s assessment of inflation being transitory has yet to show, with both the core inflation and core PCE at an elevated level and rising. While the Fed has recently upped its forecast for the year to be equivalent to that of May 2021 for Core PCE at 3.4%, the Fed does expect the core PCE rate will begin to show a modest increase of just 2.1% each in 2022 and 2023 and marginally above its target of 2.0%.

Hence, the Fed probably doesn’t want to move the Fed Fund Rate just yet, which is now at the floor of between 0.0-0.25%, knowing that its target will be reached next year.

The Fed’s argument of the transitory nature of the spike in both headline and core inflation data is not without basis. Commodity prices have rallied strongly this year, both on rising aggregate demand due to the opening up of global economies while on the other end, supply disruption too is making pushing prices up.

One doesn’t have to go far to see this as even in Malaysia, economic output has been interrupted by the National Recovery Plan and areas under the enhanced movement control order (EMCO).

Elsewhere in South-East Asia, which is the bedrock of the global supply chain, is seeing economic interruptions everywhere, from Jakarta to Bangkok and from Manila to Ho Chin Minh, governments are battling hard the rise of the fourth or fifth pandemic wave, especially the Delta and Lambda variant.

With the data showing a significant increase due to the low base effect last year, there is no denying that there is at the same time a high base effect is being build-up this year. Hence, it is likely by 2022, both the headline and core PCE numbers will begin to ease due to this high base effect instead.

Long way towards full employment

On one end, while the job market is seeing more jobs being added, the unemployment figure has remained stubbornly high at 5.9%. Last month, the gain in the non-farm payroll, which rose by 850k, was well above expectations, but surprisingly unemployment rate increased by 0.1 percentage points against the preceding month’s 5.8% print.

This is still very much higher than what the Fed’s comfort zone is, which is the point when the economy reaches full employment. In economic terms, this is typically defined as an unemployment rate of 4% or less. Not surprising as to why the Fed has set this as its target as before the pandemic, the US economy had an unemployment rate of 4% and below for two years, i.e. from between March 2018 and February 2020.

Hence, as far as the labour market is concerned, the conditions are not conducive for the Fed to take the foot off the pedal just yet as far as its bond purchase programme is concerned.

Fed’s tapering move may start in early 2022

As the Fed has pencilled in two rate hikes in 2023, it is widely believed that we will see the Fed’s tapering move starting much sooner than that. With economic conditions beginning to show signs of strength but data don’t seem to support just yet, especially on unemployment data, the Fed will probably begin to wind down its asset purchase program in a mild manner and well accepted by the market.

For now, the Fed will continue its bond purchase program, perhaps well into 4Q of 2021 and early 2022, before easing down to US$80bil (RM328bil) a month in the second quarter of 2022 and thereafter to US$50bil (RM205bil) a month in the third and fourth quarter of 2022 before eliminating it by the end of next year.

With that, the Fed’s balance sheet is expected to continue to expand and may peak at between US$9.7 trillion and US$10 trillion (RM39.77 trillion and RM 41 trillion) by the end of 2022, translating to about 42% of US nominal GDP.

Liquidity drives markets

Fed’s continuous expansion of its balance sheet suggests more room for the liquidity-driven rally to continue to fuel markets. As it is, we have seen all three main US indices hitting one record high after another. Measuring the three main US indices just before the pandemic and to the level there are today, we observed that the Nasdaq is among the best performer, having risen by about 52%, the S&P500 is up by about 31% while the Dow is higher by about 21%. This comes at a time when the Fed’s balance sheet expanded by close to 97%.

Assuming the Fed’s balance sheet expands by another US$1.8 trillion from its current level or almost 45% more than what it has already grown by, would it be safe to assume that the Nasdaq may see another 15.2% jump to 16,750 pts, the S&P500 will rise by another 10.4% to above 4,800 pts and the Dow will hit 37,500 pts, up almost another 7.6%? Only time will tell. For now, the Fed’s balance sheet has just passed the US$8 trillion (RM33 trillion) and it continues to expand.

Pankaj C Kumar is a long-time investment analyst. The views expressed here are his own.

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