Central Bank Balance Sheet Expansion, Government Deficits And Gold

November 21, 2019

New York (Nov 21)  First, I don't believe this is QE and I also don't believe the overall situation is good for risk or inflation- hedged assets such as stocks or gold. It is a symptom of a larger problem in the US financial and banking system. The securities being bought are more short term on the curve mostly T-bills and the US central bank has stated it is not an effort to push down long end rates and is in my opinion, rather to alleviate a US dollar reserve shortage in the US banking system.

As stated in the summary, the central bank may be in effect monetizing the US government deficit through buying securities from the primary dealers and in effect providing more reserves to the banking system. There is not a scarcity of US Treasuries. The increasing deficit and composition of assets held by primary dealers is essentially creating a USD reserve shortage within the US banking system that otherwise would likely be much less significant.

Without central bank assistance through balance sheet expansion to keep interbank rates down, they would spike higher partially because of an oversupply of Treasury issuance from the US government. Primary dealers, such as large banks swap USD reserves for Treasuries at government auctions drawing down interbank liquidity. Also, the previous balance sheet run-off known as quantitative tightening has drawn down reserves. Excess reserves are down 50% from 2.7 trillion to 1.35 trillion approximately.

The QE program worked through multiple channels. First, it pushed real yields lower than otherwise possible, it depreciated the USD boosting multinational competitiveness, encouraged risk-taking and led to a wealth effect on asset prices. Although there were positive effects and I support the use of the program after the global financial crisis, there are risks of exiting too slowly and it led to imbalances in global monetary flows, specifically emerging market dollar-denominated corporate debt.

This global EM dollar-debt problem is aggravated by a stronger USD. When US yields and the US dollar were falling during QE, it made sense, for example, for Brazilian or Chinese companies to borrow in dollars at lower rates. It was a win-win at the time because interest rates in the US were relatively lower and the USD was expected to fall against local currencies reducing the real burden of the debt.

The problem arises when the USD or currency in which the debt is denominated starts to appreciate against the local currency in which revenue is mostly earned. This increases the real burden of the debt. I made my case for the USD in my previous article linked here, and I believe there are going to be major negative global ramifications on risk assets and inflationary expectations because of a stronger US dollar and a breakdown in emerging markets.

The drama unfolding in the overnight rates market and resultant Fed balance sheet expansion is because banks or primary dealers are holding too many bonds and lacking USD reserves. The composition of the assets is the problem and the government running wider deficits only increases this. Many would argue Federal Reserve balance sheet expansion signals lower yields, a weaker USD and higher gold prices. I take the opposite view.

I believe the Fed in the sense that this is not an aggressive easing policy, but rather a major technical adjustment to keep the Federal Funds Rate in its target range. I think though, the Fed has been a bit reactive rather than proactive on this issue and there may be further turbulence in the interbank rate market. In my opinion, Treasury issuance will continue to push yields and the supply of bonds higher. The spiking overnight-interbank rate problem is one of the earlier symptoms of the global USD shortage problem. Gold will decline as expected-real-yields climb and the US dollar sharply appreciates.


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