Matt

It’s official - the Fed is likely to begin expanding its balance sheet again soon. For the first time since 2022. Bad takes will likely abound on X. Is this "liquidity positive" on the margin? (yes) Is this "QE"? (no) So, what's going on? And, more importantly, what does it mean for risk asset markets? Warning - this is a LONG post The first step Recently the Fed announced that QT is coming to an end. The Fed has confirmed it will stop unwinding Treasury (Government bond) holdings off its balance sheet, but will continue to unwind its portfolio of MBS (Mortgage Backed Securities). As the MBS continue to mature and “roll off” the Fed’s balance sheet, the Fed will then reinvest the proceeds into Treasury bills. This would imply that the Fed balance sheet would remain roughly flat (essentially "liquidity neutral"). This process will start on December 1. The second step However, the Fed cannot just keep its balance sheet flat over the medium-term. This is because of bank reserves. Bank reserves cannot fall too low, relative to the size of the US economy - because if they do, the whole banking system starts to break (this happened in September 2019). As the US economy grows, the financial system needs more and more bank reserves to be able to function properly. So, at some point, the Fed will be forced to actually start expanding its balance sheet again (which will increase bank reserves). And this “second step” (balance sheet expansion) may arrive a lot sooner than many expect. Recently, Fed Chair Jerome Powell said: “At a certain point, you’ll want… reserves to start gradually growing to keep up with the size of the banking system and the size of the economy.” Also, New York Fed President John Williams made similar remarks last week. FED'S WILLIAMS: FED MAY SOON NEED TO EXPAND BALANCE SHEET FOR LIQUIDITY NEEDS A lot of analysts from across the banking world are now expecting this balance sheet expansion to come as early as Q1 2026 (this makes me think there’s been some “forward guidance whispers” behind closed doors). Marco Casiraghi, of Evercore, said: “We think the Fed will start buying enough Treasuries to grow the balance sheet again in the first quarter of next year.” Most analyst estimates put the expected pace of this balance sheet expansion at around $20bn per month, or around $240bn per year. To be honest - this is balance sheet expansion for ants. $20bn might seem like a big number - but in the grand scheme of things, it’s a tiny number. To put it in perspective - between March 2020 and June 2020, the Fed increased the balance sheet by more than $3 trillion - or more than $800bn per month. If the Fed were to continue to expand the balance sheet at a pace of $20bn per month - it would take roughly ten years just to return to the balance sheet highs of early 2022. These developments are not a surprise. Fed guidance has been laying this out for years. The plan has always been to grow the balance sheet slowly, at the same pace as GDP growth. This is not intended to stimulate the economy or asset markets - it’s to ensure that the banking system has enough reserves as the economy grows. Here’s a chart showing balance sheet projections from a Fed paper in early 2024. Bills, bills, bills Notice - the Fed has explicitly stated it is planning to purchase Treasury bills (short term - one year or less). This is a very important distinction in terms of any potential impact on risk asset markets. The Fed purchasing Treasury bills is somewhat liquidity positive, on the margin. But nowhere near as liquidity positive as if the Fed were to buy Treasury coupons (2-30 year). Technically, it’s not really “QE” unless the Fed is buying coupons. It’s more accurately described as "reserve management” - some people may label it as “QE-lite”, but I think even this is a stretch. In previous waves of “real QE” - like 2020 and 2021 - the Fed hoovered up huge amounts of Treasury coupons. So, the Fed was “removing duration risk” from the market. This is really the key asset price boosting power of “real QE” - this “removing of duration risk”. While the Fed buying bills is still liquidity positive on the margin - it is nowhere near as “potent” as previous “real QE” waves in terms of its impact on risk asset markets, because it doesn’t affect duration. So we have: 🔘 Balance sheet expansion for ants ($20bn per month) 🔘 “Less potent” balance sheet expansion (buying bills instead of coupons) In my view, this very slow buying of bills will have minimal direct positive impact on risk asset markets. But due to the avalanche of bad takes that will likely abound - the positive psychological impact may be larger. It's likely a bearish factor for the Dollar Index (DXY), on the margin. But wait a second... We can now get really nerdy. There is a plausible (and sneaky) way that this wave of balance sheet expansion could have similar effects to previous episodes of “real QE”. And that is all to do with what the Treasury is doing. The Treasury is constantly issuing new debt (Treasuries) to finance the Government’s ballooning debt pile. It can choose how much of this new debt is bills, and how much is coupons. In recent years, starting with previous Treasury Secretary Janet Yellen in 2023, the Treasury has heavily shifted issuance away from coupons and towards bills - so the “debt mix” has become much more “bill heavy”. This does have similar market effects to “real QE” - because it’s essentially “removing duration risk” from the market (“liquidity positive” overall). This tactic has been described as “Treasury QE”, “stealth QE” and “Yellen-omics” - and it has helped to power risk asset markets upwards in recent years. If, in the coming quarters, the Treasury decides to push overall debt issuance even further towards bills (thereby issuing less coupons) - essentially “removing more duration risk from the market” - while the Fed is also buying bills, this would technically have similar market effects to “real QE”: the Fed expanding its balance sheet and duration risk being removed from markets. So, to determine whether this might potentially happen - we need to watch the Treasury’s QRA (Quarterly Refunding Announcement). The latest QRA (released last week) signals that this further curbing of coupon issuance is not likely to happen - in fact, it hints at the opposite. Here’s the key line: “Treasury has begun to preliminarily consider future increases to nominal coupon auction sizes” This means the Treasury is considering increasing issuance of coupons - or “adding duration to the market” (“liquidity negative” overall). Now, Treasury officials may be “considering” increasing issuance of coupons and they might talk big - but whether they actually do or not is another question. If they do - this would not be good news for risk asset markets, all else being equal, and would likely completely counteract whatever the Fed is doing and then some. It could mark the end of the “Treasury QE” gravy train. Arguably, watching what the Treasury is doing is much more important than watching what the Fed is doing. Here’s what we know is likely to happen: 🔘 QT stops on December 1 🔘 The first step is to keep the balance sheet flat 🔘 Then, probably not long afterwards, the Fed will start to expand the balance sheet again 🔘 This will be achieved through buying bills (not coupons) and is therefore not technically “QE” and nowhere near as “potent” as “real QE” 🔘 It will also occur at an extremely slow pace ($20bn per month) 🔘 Arguably, the more important factor here is what the Treasury is doing