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https://www.theage.com.au/business/...pe-all-hell-breaks-loose-20200121-p53t9v.html

US Fed is caught in a trap - if it tries to escape all hell breaks loose

Stephen Bartholomeusz

Jan 21, 2020

There’s something quite odd about a sharemarket that rises more than 26 per cent over a year in which world economic growth was the weakest since the financial crisis.

That is, however, what the US market has done (the Australian market has risen just over 20 per cent) even though US GDP growth last year was only just above 2 per cent.

A recent Wall Street Journalsurvey of US economists produced an average forecast for US growth this year of only 1.9 per cent.

Expectations of modest growth, however, oughtn’t to be enough to explain why markets are at levels that appear euphoric.

The better explanation for why the stock markets have been surging – they are up about 3 per cent already this month – lies with the usual suspect.

It would appear that it has been the US Federal Reserve Board’s response to the seizure in the US "repo" market last September that has driven sharemarkets to new heights. Since that market froze in mid-September, with rates soaring as liquidity disappeared, the US sharemarket has risen almost 11 per cent.

Repo markets provide short-term liquidity to companies and institutions in exchange for high-quality collateral such as US Treasury bills. The borrower sells the securities for cash while simultaneously contracting to buy them back in the near term – as little as 24 hours – for a slightly higher price.

The Fed did two things in response to the malfunctioning of the repo market.

It injected and has continued to inject massive doses of short-term liquidity, providing at least $US120 billion ($175 billion) of overnight and 14-day cash each month in exchange for high-quality collateral through its own repo facilities.

It also, moreover, started buying Treasury bills at a rate of $US60 billion ($87 billion) a month.

It has done so because it believes that, as it reduced the size of its balance sheet by allowing securities it purchased during its three big post-crisis quantitative easing (bond and mortgage-buying) programs, bank reserves – the cash they hold with the Fed – have also fallen to levels too low to enable them to lend enough cash into the repo market.

The story is slightly more complicated than that because a strand of the explanation for the banks' inability to deploy their reserves is the post-crisis prudential reforms that force them to hold more high-quality liquidity of their own, leaving fewer of the reserves available for lending.

During the Fed’s quantitative easing, or QE, programs, its balance sheet expanded from about $US900 billion ($1.3 trillion) to a peak of about $US4.5 trillion ($6.5 trillion). The Fed halted that expansion late in 2015 and started shrinking the balance sheet in October 2017, reducing it to less than $US3.8 trillion ($5.5 trillion) just ahead of the repo market crisis.

Since then the central bank’s Treasury bill purchases has seen the balance sheet growing again. It now sits at about $US4.2 trillion.

More than any other influence, it is that massive injection of liquidity from the Fed’s buying of Treasuries that has underpinned the markets’ rise.

The phase one trade deal between the US and China has helped remove some recent risk from markets but it has been central bank action that has underwritten asset prices generally - and record sharemarkets in particular -since the markets stabilised in March 2009.

The Fed has said it will maintain its repo market interventions until at least the middle of next month and indicated it hopes to stop buying Treasury bills by the middle of the year. Markets are sceptical.

The problem the Fed and other central banks confront is that, when market levels are predicated on ever-cheaper cash being freely available, even the faintest threat that the cash might become more expensive or less available causes shockwaves.

In the final months of 2018, when the Fed signalled it might increase the pace of normalising US monetary policy, markets imploded and the Fed was forced to halt its planned continued shrinking of its balance sheet and reduce interest rates rather than continue with its planned increases.

The out-working of the repo market malfunctioning and the Fed’s response to it is another illustration of the trap central banks have created for themselves.

They have left their unconventional policies in place for so long after the GFC and their abnormal interventions have been of such a magnitude that they have encouraged risk-taking and a build-up of financial leverage that inhibits their ability to "normalise" their policy settings without triggering destructive convulsions.

There is too much debt, too much activity predicated on ultra-low interest rates and too many asset values that have been inflated to allow the major central banks any real scope for withdrawing liquidity or raising rates.

There’s been debate about whether the Fed’s repo market interventions represent a resumption of QE (the Fed denies it) but it certainly looks like QE, has similar effects and has been embraced by investors as if it were QE4, or at least QE3.5, and here to stay.

The QE programs were designed to encourage risk and that’s what investors have been doing, in spades, confident the Fed won’t remove the punchbowl from the party while it is in swing because of the market meltdowns and wealth effects that would generate.