Has the Taper Finally Started? Who Will Fill the Massive Gap?
While on the surface, it appears the Federal Reserve asset purchase taper has started, it’s not as easy to prove when you dig into the details.
The Fed is certainly not being as aggressive as they promised, and for good reason. As the Fed leaves the bond market, who will fill the gap? Since 2019, the Fed has quadrupled the Treasury purchases of international holders and has been one of the biggest players in the Treasury market.
Breaking Down the Balance Sheet
The balance sheet analysis in November showed how the Fed Taper failed to begin, with $126B being added. As noted, this was due to MBS purchases increasing to $80B. This month, the Fed added $73B in Treasuries but only $5.7B in Mortgage-Backed Securities (MBS), while allowing $3.4B in Repo agreements to roll off the balance sheet.
The balance sheet net gain came in quite a bit lower at $76B for December.
The chart below shows the balance sheet grew at the slowest pace since January. The subsequent table shows how the balance sheet has now reached $8.75T, down slightly from $8.79T the week before.
Figure: 1 Monthly Change by Instrument
Figure: 2 Balance Sheet Breakdown
The Fed is currently targeting $60B a month in Treasuries (soon to be $40B) and $30B a month in MBS (soon to be $20B). Based on the totals, it looks like the Fed is not only tapering but doing so “aggressively.” However, the truth is more nuanced.
When looking at the weekly data, things begin to make more sense. As highlighted last month, due to the unusually high increase in MBS, December was likely to have distortions as well. The weekly chart below shows how things unfolded. December saw two large MBS maturities because the one that would have occurred in November was pushed forward.
Figure: 3 Fed Balance Sheet Weekly Changes
The Fed appears to work 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 and 5-10 year have well exceeded the 24-week average
- Maturities < 1 year and > 10 year are below the 24-week average
- MBS security purchases are also above the 24-week average, more in line with the 52-week average
In total, the last 4 weeks have seen an average increase of $26.7B ($106B in total). This exceeds the 24-week average of $23B and is on par with the 52-week average of $26.8B. This despite quite a large slowdown in the most recent week, potentially due to the holidays.
Figure: 4 Average Weekly Change in the Balance Sheet
It’s rather difficult to determine if purchases have actually slowed by a significant degree. Interest rates are not providing conclusive evidence either. Rates on 2-year notes have increased by 50% from 50 bps to 75 bps. However, rates on the 10-year and 30-year are both down since the Taper started and the 5-year is up slightly by about 5bps.
Figure: 5 Interest Rates Across Maturities
The Fed Monetization
The Fed has been monetizing almost all the federal government debt for the last two years. As can be seen 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 4 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 31% and 46.5% respectively, but the Treasury has issued more debt in Notes and Bonds this year than last year. Furthermore, +30% is still massive debt monetization!
Who can step in to replace such a massive buyer? Who can absorb almost half of the long-term debt the Treasury will be issuing for the foreseeable future? If/when they exit, how long can the Fed actually stay out of the Treasury market?
Figure: 6 Debt Issuance by Year and Instrument
Figure: 7 Fed Purchase % of Debt Issuance
Who Will Fill the Gap?
The Treasury publishes international holders of debt on a monthly basis with a two-month delay. Since Aug 2019, The Fed has increased its balance sheet of Treasury securities by $3.5T from $2.1T to $5.6T. At the same time, international holders have increased their holdings of US debt by $900B as shown below. This means the Fed has almost quadrupled the purchases of the rest of the world combined over the last 2+ years! When the Fed steps away, who will step up?
China has been steady at $1.06T since Dec 2019, which is down $200B since it was holding $1.26 back at the end of 2015. Japan has made up for China’s absence, increasing holdings from $1.15T in Dec 2019 to $1.32T. The UK has also increased its holdings from $332B to $580B since Dec 2019. Unfortunately, even though these represent fairly large percentage increases for each country (14% and 74%), the dollar amounts pale in comparison to the massive amount being absorbed through Quantitative Easing.
Figure: 8 International Holders
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 2017-2019 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 might hit $9T before the Taper ends. If not, it won’t be long before it does, and then eventually takes out $10T. It’s the only option if the Fed wants to keep the bubble economy going.
Figure: 9 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 this year. The government needs this monetary support or else rising long-term rates will put pressure on the Federal Deficit.
The Fed is attempting to Taper, but the math is working against them. They will inevitably reverse course and begin expanding their balance sheet by more than $120B a month. This will continue driving the Money Supply higher putting downward pressure on the dollar and upward pressure on inflation. Do they have the tools to fight inflation? Absolutely. But the implications of doing so are so politically devastating that they will choose higher inflation over a collapsing economy. 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: Dec 29, 2021