Understanding the Federal Reserve Balance Sheet


The Federal Reserve released news recently that it would be increasing its balance sheet by another trillion dollars. However, most investors don’t know what the Fed’s balance sheet is or how it could affect their trades and portfolio.

2 February 2020 | HYCM – The Fed is going to continue adding cash into the banking system by buying billions of Treasury bills for a few more months. However, it wants to start cutting back these purchases in Q2 according to Jerome Powell on this week’s rate meeting.

Why did the Fed start buying Treasury Bills?

The Fed did this in response to a surge in borrowing costs in bank funding markets last Autumn. In order to keep providing liquidity in the US money markets, the Fed propped up the gap.

The Federal Reserve had acquired a large catalogue of Treasuries and mortgage-backed securities after the 2008/9 financial crisis through three quantitative easing programmes (known as QE or asset purchases/ easy money). The purpose of QE was to drag down long term bond yields and reduce the cost of borrowing.

2017

Then in 2017, the Fed started to reduce the amount of these asset purchases. The amount of these purchases is known as the Fed’s balance sheet. Last August the unwinding of QE, by reducing the balance sheet, ended August 2019. However, in September 2019 the money market reaction was that the balance sheet was now too small.

The Fed responds

The Fed responded through daily cash injections in the repurchase agreement market. Known as the repo market. On top of this, the Fed started buying Treasury Bills to get bank reserves levels up.

The extent of the Fed’s purchases

The Fed has been buying around $60billion a month of T-bills and reserve levels have risen more than $270 billion to roughly $1.67 trillion. He said that the bottom end of his range and floor is $1.5 trillion as that was the level around which liquidity problems arose. Powell wants to slowly reduce support here, but he has given no timeline to how he will taper these purchases. Take a look here at the impact on the asset purchase chart below.

Fed Balance Sheet

So, who cares about the Fed balance sheet?

Equity investors are concerned. Some people are arguing that the latest move by the Fed is QE in disguise and is what has been supporting the latest bull run in US stocks. The thinking is that the Fed is signaling that they will step in to catch a falling market. Uncle Sam (well the one in the Fed, at any rate) will save the day when and if the going gets tough.

What’s the trade?

A sudden halt or stop in the balance sheet will hit US stocks. Short S&P500 is the vanilla option in this instance, but the Fed will likely signal a gradual reduction. However, I hope that this lifts the fog on ‘repo markets’ and ‘balance sheets’ if you have been letting that wash over your head recently. If you like this article give it a like or a recommendation as it lets me know how useful or otherwise these kinds of articles are.

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