The Fed is talking taper. But it seems to be having a hard time actually tapering. The central bank added another $100 billion to its balance sheet in January.
Last month, we discussed the potential issue with the Fed leaving the treasury market, showing that international buyers had really stepped away from the table. It’s no surprise that by month three of the taper, the Fed is still struggling to exit the market.
And it will most likely find the same difficulty in raising interest rates four times in 2022 despite the current forecasts.
Breaking Down the Balance Sheet
The Fed added $103B to its balance sheet in January. This was divided across $45B in MBS, $64B in Treasuries, and -$9B in Repos. These numbers are very surprising given that according to the Fed’s own website they planned to purchase on average $50B in Treasuries and $25B in MBS over this time period.
The Fed has started to hint at even shrinking its balance sheet, but how is that possible when it’s still adding $100B+ a month? It almost doubled its target rate of MBS and was 30% higher than its Treasury target.
Figure: 1 Monthly Change by Instrument
As shown in the table below, the Balance Sheet now stands at $8.86T, down $7B from the record set last week. The balance sheet will almost certainly exceed $9T by the time the Fed completes its taper. The taper is supposed to complete in March, but that is in less than two months. It’s still adding $100B a month in assets!
- Additions were made across the yield curve
- Only 5–10-year maturities saw a reduction in January
- MBS increase was greater than the original $40B target
- “Other” (repurchase agreements} have been slowly unwinding for over a year now
Figure: 2 Balance Sheet Breakdown
When looking at the weekly data, the past several weeks do not look all that different from how things looked prior to the taper onset. Aside from the week ending Dec 29 (5th bar from the right), the Fed continues to add week over week. A large maturity of 5-10 year fell off the balance sheet last week totaling $15B. That is the only activity preventing the current growth from being at the original target before the taper.
Figure: 3 Fed Balance Sheet Weekly Changes
The Fed works on a 4-week cycle. Thus, to normalize the data a bit more, the table below shows weekly average purchases over 4, 24, 52, and 156 (3 years) weeks. The weekly averages are shown to gauge whether the current periods (1 and 4 weeks) are accelerating or decelerating.
When looking at the 4-week average:
- Maturities 1-5 year exceeded the 24-week average
- Maturities 5-10 year and > 10 year are below the 24-week average
- MBS security purchases are at the 24-week and 52-week average
In total, the last 4 weeks have seen an average increase of $25.7B ($102.8B in total). This exceeds the 24-week average of $25.1B and is just below the 52-week average of $28B.
This is not a taper!
Figure: 4 Average Weekly Change in the Balance Sheet
Despite the Fed keeping its foot on the gas, interest rates have really started moving up. Rates on 2-year notes have skyrocketed from .14% to 1.13%. The 5-year and 10-year also sat at 18-month highs. The chart below shows a rapidly flattening yield curve. What happens if the Fed actually exits the market and actually starts hiking rates? These charts could go vertical!
Figure: 5 Interest Rates Across Maturities
The Fed Monetization
The Fed has monetized almost all the debt for the last two years. As shown below, the Fed has absorbed a large percentage of debt issued since Jan 2020. The focus is clearly seen in Notes and Bonds to keep a lid on long-term rates. The first chart shows the debt added by the Treasury in each of the last 3 years by instrument.
The bottom chart shows the percent of that debt the Fed has purchased. In 2020, the Fed monetized more than 100% of notes and 90% of bonds. In 2021 those numbers have fallen to 30.5% and 46.1% respectively, but the Treasury has issued more debt in Notes and Bonds this year than last year as shown in Figure 4. Furthermore, +30% is still massive debt monetization!
Even with the Federal Deficit shrinking from higher tax revenues, the market will struggle to absorb all the new debt on its own.
Figure: 6 Debt Issuance by Year and Instrument
Figure: 7 Fed Purchase % of Debt Issuance
Who Will Fill the Gap?
The chart below looks at international holders of Treasury securities. Since January 2020, the rest of the world has not purchased even $1T despite the Treasury adding $4.5T in 2020 and $1.9T in 2021
Figure: 8 International Holders
The next chart details the distribution of the Fed balance sheet. Even though it was aggressive in buying MBS, the last two years have seen a major push to increase the relative holdings of Treasuries. As the world stepped away, the Fed stepped in. With the Fed stepping away, who will step in to keep rates in check? Again, maybe this is why the taper is happening slower than forecast.
Figure: 9 Total Debt Outstanding
The final plot below takes a larger view of the balance sheet. It is clear to see how the usage of the balance sheet has changed since the Global Financial Crisis. The tapering from 2017 to 2019 can be seen in the slight dip before the massive surge due to Covid.
There is no way the Fed will come close to shrinking the balance sheet at this stage. With more Fiscal spending on the horizon and an economy addicted to low interest rates, it is probable that the growth of the balance sheet may accelerate rather than decelerate. The Fed is on course to hit $9T before the taper ends. It most likely won’t hit $10T this year, but it’s highly probably the Balance Sheet will exceed $10T rather than retreat below $8T in the years ahead.
Figure: 10 Historical Fed Balance Sheet
What it means for Gold and Silver
The Fed is in a box. They cannot let interest rates rise or else the entire economy will come crumbling down, but if they keep the monetary stimulus flowing then inflation will most likely spiral. As shown above, they have monetized a huge amount of the US Debt the last two years. The government needs this monetary support. The Fed is claiming to raise interest rates 250bps over the next several years, but this is mathematically impossible!
The Fed is finding it easier to talk about tapering rather than doing it. Will the same prove true for interest rates? Probably. This will most likely result in persistent higher inflation and a fall in the dollar. Gold and silver will provide excellent protection during this time.
Ignore the short-term fluctuations. The market is pricing in an aggressive Fed. Nothing could be further from the truth, if you trust the math and the data. Real interest rates will remain negative for the foreseeable future.
Data Updated: Weekly, Thursday at 4:30 PM Eastern
Last Updated: Jan 26, 2022
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