Pedro da Costa, maybe the smartest and best reporter covering the Fed, and who seems like a good guy, has a blog post out today suggesting that the $50 billion ECB dollar lending operation today will cause the Fed’s balance sheet to expand. He’s piggy backing on Mike Derby’s column in the Wall Street Journal, most of which is behind a paywall, so I don’t have the full story on that. I think that the conclusions are unwarranted, or at least premature, until we see the Fed’s H41 statement for this week or next, depending on when the funding settles. If not same day, the effect would not show up until next week’s H41.
Da Costa’s piece implies that one result of the loan will be a jump in the Fed’s custody accounts of foreign central bank holdings of Treasuries and Agencies and that that would somehow imply an increase in the size of the Fed’s balance sheet. First, even assuming all of the $50 billion came via swaps with the Fed, custody holdings are custody holdings. They are assets of foreign central banks. They are not part of the Fed’s asset base. There is no direct connection between the swaps and the custody holdings. I have no clue why he thinks that the ECB lending dollars to its constituent banks would cause an increase in FCB holdings of Treasuries and Agencies. If the ECB is investing those dollars in loans to banks, then they can’t be buying Treasuries with them. The point he makes there, makes no sense in that respect.
In fact, sale of those custody holdings would be one means by which the ECB could have raised the $50 billion in USD to fund these loans. That would have NO IMPACT on the Fed’s balance sheet. It would not involve the Fed supplying one red cent.
Even if we assume that the Fed does fund the swaps, there are a number of ways that can be done and simultaneously sterilized. Even beyond sterilizing the impact, there are ways it may be accomplished which would actually shrink the balance sheet!
In fact, the Fed’s balance sheet has been shrinking since June as MBS holdings have been paid down, and the replacement MBS purchases have apparently all been 60 day forwards. As a result, the Fed’s assets have shrunk by about $50 billion since July, and, all other things being equal, would not begin to rebuild to the $2.654 trillion SOMA target until the purchase program is complete this coming June, and the settlements continue through August. The point here is that the Fed has shown no inclination to grow its balance sheet. There’s been a lot of hot air about it, but they haven’t pulled the trigger.
I reported to Professional Edition subscribers last month the big withdrawal from the bank reserves deposits at the Fed that went into Other Deposits. I tried, but failed, to interest any mainstream reporters, including your friend and mine Mike Derby of the Wall Street Journal, and Greg Robb of Marketwatch, in this massive transfer. There have now been several massive deposits and withdrawals between bank reserves and Other deposits on the Fed’s balance sheet in the past several months. The net amount remaining in Other was $52.8 billion last Wednesday. That’s a sea change from the nominal amounts typically held in Other deposits.
“Other,” as defined by the Fed, includes “foreign official organizations,” along with GSE direct deposit accounts at the Fed, and the account of the US ESF, aka the Plunge Protection Team.
Since we are making assumptions, let’s assume that the $52 billion are mostly funds of “foreign official organizations.” If these are ECB funds and the ECB withdraws them to fund these dollar loans, this would force the Fed to either borrow the dollars itself, which would seem to be a non starter under current market circumstances, or sell SOMA Treasury holdings outright, thereby SHRINKING rather than expanding the Fed’s balance sheet. The Fed could not on the one hand see its liabilities reduced and its assets increased. It cannot “reprint” a withdrawal of money that was already in existence and on deposit. The immutable law of double entry accounting would not allow it. The Fed would have to sell assets to fund the withdrawal, i.e. the reduction of the existing deposit liability under this scenario.
Now I have no clue what WILL happen, but neither does Mike Derby, unless he just got off the phone with the Fed’s media leak line. Maybe he’s right, maybe not. If they are right, then the commodity speculators will swing into action. But if they are wrong, and the loans are funded via means such as described above, the implications would be bearish for stocks and commodities. Because I like Pedro, I want to warn him that we should wait until the data is in before we jump to conclusions and maybe end up with reportorial contusions.
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