What can the U.S. Treasury’s attempts to keep paying the nation’s bills tell us about the Federal Reserve’s quest to reduce its balance sheet after years of stimulus?
Quite a lot, according to Zoltan Pozsar, research analyst at Credit Suisse Group AG in New York. He suggests that by focusing on the ambitions of most Fed officials to begin reducing the central bank’s asset holdings this year, investors may be missing a crucial — often over-looked — role of the U.S. government in driving global money supply.
“Big is beautiful. Big is necessary,” Pozsar writes. “Learn to live with it.”
Because of a deal struck to avoid a debt-ceiling showdown during the presidential elections, the Treasury has been cutting its cash balances at the Federal Reserve Bank of New York, helping to boost liquidity and forcing a retreat in the metric the Bank for International Settlements recently crowned the market’s new fear gauge.
The measure of how much it costs to convert local payments into dollars from Japanese yen for example — called the cross-currency basis spread — has cheapened recently in part because the Treasury has tapped cash balances. That has freed-up more funds to be used for arbitrage opportunities, providing a conduit for foreign banks and investors to procure dollars more cheaply and keeping global monetary conditions relatively loose.
But this stop-gap procedure stands in stark contrast to what the Fed — often called the world’s central bank — has been mulling as it seeks to wind down years of extraordinary stimulus that have swelled its balance sheet to $4.5 trillion. It suggests that the cost of converting currencies into greenbacks could rise again once the temporary phenomenon of the debt ceiling drama abates, according to Pozsar, tightening financial conditions.
The “extraordinary measures” by the Treasury “drove the collapse of cross-currency bases,” he says.
In considering balance sheet normalization, the Fed may first look to acknowledge how recent market trends set in motion by the Treasury would work in reverse — and how global financial markets would react if the Fed added to those pressures by shrinking its own balance sheet, he adds.
Fewer reserves, in turn, mean a higher cost of obtaining U.S. dollar funding. The analyst estimates that each $100 billion of reserves drained by the Fed is equivalent to a 10 basis point increase in cross-currency bases — or, as Pozsar dubs it, a 0.10 interest rate hike for the rest of the world. As a shrinking balance sheet ripples across financial markets, upending global borrowing costs, the Fed could come under pressure to reconsider its plan.
“Reserves are far from being ‘excess’ — they are needed and are being traded actively,” he concludes. Government “measures to avoid the debt ceiling have put $400 billion in reserves back into the financial system, which drove the collapse of cross-currency bases. What this tells us is that the Fed has only limited room to shrink its balance sheet.”