The Fed's balance sheet is now at $6T, which is too large for them to unwind. This only ends in one of two ways:
1. A massive asset bubble and a fundamental re-evaluation of risk/reward ratios for all investments. Historically, the average P/E ratio for S&P 500 companies is around 16. Roughly speaking, this means that investors are comfortable making their investment back in 16 years in static market conditions. Does this decision calculus change if you know that the Fed will bail you out as soon as times get tough? You bet it does. Similarly, corporations are much more incentivized to take on as much debt as possible in hopes of inflating their stock prices. When times are good, massive bonuses for execs all around. When times are bad...hey, bailout! I expect the "new normal" for P/E ratios to be in the 30-50 range. In the short term (next decade or so), this means the party continues, and we see massive growth in the stock market. But when the bubble pops, it'll pop harder than ever...
2. The second scenario is that debt-holders worldwide lose faith in the dollar and start dumping Treasuries, leading to hyperinflation. This doesn't seem to be happening as of today, in fact, the more money the Fed prints, the stronger the dollar. Central banks worldwide are printing money as well, so the dollar looks like the "least ugly" choice by comparison. The big unknown is how long the Fed can keep printing before debt-holders start second guessing the dollar's value.
3. Dollar devaluation through expansion of the balance sheet even further.
The BoJ balance sheet is about 100% of GDP. The Fed balance sheet is about 30% of GDP. That gives a lot of room to add assets before the US looks anything like Japan in that department.
This balance sheet expansion could happen against a backdrop of stock prices that would otherwise be falling. Expanding the balance sheet through stock purchases allows the Fed to correct the global dollar short squeeze while preventing calamitous stock repricing at the same time.
Nominally, things wouldn't look much different to those in the US. But in real terms, the result would be crushing. It seems, however, that politicians and many voters only consider nominal returns, not real returns.
This is one of the reasons I find it hard to believe people who claim the Fed is "out of ammunition." We're at the level of bazookas now, but the Fed has everything from that to nuclear ICBMs and more to play with courtesy of the dollar's reserve currency status.
If corona turns out worse then anticipated for the US and Trump insist on ending his term on a high stock market in 8 months time, the damage could have already been done.
If the Fed got it up to 100% of GDP (or whatever is considered extreme after this crisis) the status of 'reserve currency' will be in jeopardy.
Being the 'reserve currency' is all there is to the dollar, and the US has successfully leveraged it for more than 50 years.
However, if it comes into question, the collapse of the US will be almost instantaneous.
The ICBM's are for show, no sane person would ever fire them.
imho we are going to see something like both scenarios... scenario 1, then scenario 2.
Also, when you say "in fact, the more money the Fed prints, the stronger the dollar", I don't think this is quite the case. The supply of US dollars isn't enough to match the global demand for US dollars. The Fed is having to "print" (basically enter some numbers into a computer) dollars to meet this demand otherwise it causes havoc... perfect example is the repo market spiking and the Fed having to intervene.
For a good explanation search for the 'dollar milkshake theory' by Brent Johnson.
I agree that the Fed's interventions can't keep on going... each intervention creates market distortions that end up requiring more interventions. However, one of my economics professors used to say, “In economics things take longer than you expect, and go quicker than you expect”. So, I take that to mean that the Fed will ‘save the day’, continue to distort the market, and we will have a catastrophic unwinding of the debt.
In terms of how I'm going to protect myself, I looked long and hard at Ray Dalio’s ‘All Weather Portfolio,’ but I've decided to implement Chris Cole's ‘Dragon Portfolio’ (search for ‘The Allegory of the Hawk and the Serpent’) with a tactical overlay taken from Seth Klarman's out-of-print investing book, 'Margin of Safety' which I highly recommend.
How are you implementing it in practice? I would like to implement it myself but at this point it requires a fair amount of effort to do so. Are you aware of any retail solutions that are similar to buying into an index - some sort of dragon portfolio index?
I think this is what it looks like when the government becomes more activist in the overall running of the economy.
The pendulum swings. We had a lot of government involvement in the 40/50s. It declined through the 60s and 70s until we got peak deregulation in the 80s. People forget that near-free telephone calls and cheap flights everywhere were a direct result of all the deregulation. Now I see things swinging back. Maybe it's generational, we forget/become blind to how good we have it, and only see the disadvantages, and then swing back the other direction.
My sense is that we're heading toward something more like China with all the good and bad that entails. Much closer cooperation/coordination between the federal government, industry, finance, and academia. Government that doesn't let big business fail, more stable and "guaranteed" employment/income for people, more state direction of the economy. More emphasis on big firms, "national champions" (Trump creating the CEO advisory council with Apple/Tesla/etc. CEOs, bailing out Boeing), America-first (China-first!) industrial policy, and limited scope for foreign ownership/takeovers (US blocking ZTE's takeover of Qualcomm, arresting Huawei execs in Canada). With the accompanying reduction in freedom of expression, individual rights, ease of hiring and firing, economic freedom, and overall dynamism/ability to adapt and invent new things.
It's been heading this way for a while and frankly, seems to be what people want. Massive escalating bailouts every 10 years, and a serious push for a socialist, worker-first government. It seems there's been some kind of deep shift in our culture away from risk-taking and more toward the stable academic/government/state-directed way of life.
Look at all the main street businesses around you, especially hotels, dry cleaners, diners, gas stations, auto repair shops. It's striking how many were started from about 1940-1970 or so. Nobody wants to own or operate this stuff anymore. Everyone would rather go to college, get a stable job at a big, high-paying, high-productivity company, usually that offers good insurance, paid parental leave, etc. and work there for a long time, or hop between various versions of this same arrangement for a few years at a time.
100% spot on analysis. This is bailing out the rich strategy again. Gotta be ready to ride this wave up if you can, but oh man is this gonna hurt when it pops.
Scenario 2 is your number 1, just one step further in the past. Dumping treasuries leads to you having dollars, you've basically switched from interest-bearing (admittedly super low interest rate right now) to non-interest bearing (cash). You still need to put the money somewhere, hence asset bubble.
Also, why does the government debt "bubble" ever have to "pop"? Does everyone still believe the government has to "pay off the debt"?
They don't. Ever. For a large number of reasons, to name just a couple:
- No more treasuries or bonds (how many people would freak out if those no longer exist)
- They can print more money forever. Besides, at this point it's just numbers in the FED computer system. Hardly any of it even exists as a physical object (paper, coins).
Also, I'll let you in on little secret. The Fed is never going to fully unwind its balance sheet.
>Dumping treasuries leads to you having dollars, you've basically switched from interest-bearing (admittedly super low interest rate right now) to non-interest bearing (cash). You still need to put the money somewhere, hence asset bubble.
The balance sheet can be unwound simply by waiting for the bonds to expire, then the money goes poof out of existence the same way it poofed into existence.
What the fed has been doing though, is rolling the money into new bonds, keeping the total balance ~constant. If they didn't, it would leave a $4T hole in the bond market that would suddenly need to be filled.
The balance sheet can be unwound simply by waiting for the bonds to expire, then the money goes poof out of existence the same way it poofed into existence.
How would that work? The money's been created and has been put into the economy. Balances on bank accounts have increased. You can't just take it back just like that.
When the bond matures it must be paid back, and the money that was created when the Fed purchased it is now destroyed as the Fed receives the bond principal.
If the bond is not paid back and the debtor defaults, well... this can't happen with US Treasuries because the fed is an arm of the government and will always roll over a bond. But if it happens with the corporate bonds that the Fed is buying, then the US Treasury is on the hook for the losses because by law the Fed cannot be impaired.
In the aftermath of the 2008 financial crisis, the Fed managed to unload a mere $800B (balance sheet went from $4.5T to $3.7T) in the longest bull run in history. Now that it's an order of magnitude bigger, you can draw the logical conclusion yourself.
It'll take a while to unwind, no doubt about that.
The Fed currently holds ~$5.8 trillion, but it's long term holdings are about ~$1 trillion in current dollars, so it's holding an addition ~$4.8 trillion above what it normally has since the early 2000s.
In October of 2014, it held ~$3.7 trillion, or ~$2.7 trillion above what it normally holds, so the recent increase to $4.8 trillion above baseline isn't quite an order of (base 2) magnitude increase.
Having said all that, the net worth of households and non-profits in the US is about ~$118 trillion.
Love it when people cite FRED. Top quality data source and one of the best litmus tests for the credibility of someone's claims on economic matters. This guy knows what he's talking bout. Good job!
Ok, thank you. I found a page as well on the "so what" of that. http://www.crfb.org/blogs/cbo-consequences-growing-national-... . It would be interesting to pontificate about how much USD the Fed can print before it does have these bad impacts. Currently it seems we're in a deflationary period bc the velocity of money has gone down so much and people are holding cash. Will be interesting to see how much inflation there is down the line after the $500B extra they're printing now.
The Weimar Republic had debt obligations that it couldn't repay and so they printed money. Meanwhile the balance sheet of the Fed is just that. A balance sheet. The only way they can create inflation is by making the balance sheet bigger. As long as inflation is below the target they can just keep increasing the balance sheet. There is no obligation to decrease the balance sheet unless inflation is above the target.
Why are they even doing this in the first place? The Fed buys assets during deflation and sells assets during inflation. Buying a cheap asset (e.g. $50 for a share) with money created from thin air increases the money supply and over the long run increases inflation. Inflation causes the prices of cheap assets to rise above the original value to $100 for a share. The situation is out of control! What can the fed do? It can sell assets in exchange for $100. In other words. The fed never runs into a situation which it cannot undo.
The problem, you see, is that the money issued by the Fed is used all over the world through the magic of repo, while CPI is measured within the United States only. Ever heard of the shadow banking system? Eurodollars?
1. A massive asset bubble and a fundamental re-evaluation of risk/reward ratios for all investments. Historically, the average P/E ratio for S&P 500 companies is around 16. Roughly speaking, this means that investors are comfortable making their investment back in 16 years in static market conditions. Does this decision calculus change if you know that the Fed will bail you out as soon as times get tough? You bet it does. Similarly, corporations are much more incentivized to take on as much debt as possible in hopes of inflating their stock prices. When times are good, massive bonuses for execs all around. When times are bad...hey, bailout! I expect the "new normal" for P/E ratios to be in the 30-50 range. In the short term (next decade or so), this means the party continues, and we see massive growth in the stock market. But when the bubble pops, it'll pop harder than ever...
2. The second scenario is that debt-holders worldwide lose faith in the dollar and start dumping Treasuries, leading to hyperinflation. This doesn't seem to be happening as of today, in fact, the more money the Fed prints, the stronger the dollar. Central banks worldwide are printing money as well, so the dollar looks like the "least ugly" choice by comparison. The big unknown is how long the Fed can keep printing before debt-holders start second guessing the dollar's value.