Does Fed Balance Sheet “Normalization” Signal The Next Asset Collapse Has Begun?

Authored by Chris Hamilton via Econimica blog,

After nearly a half century of unlimited dollar creation, multiple bubbles and busts…the current asset reflation has been the most spectacular…but alas, perhaps too successful. The Fed’s answer to control or restrain this present reflation is raising interest rates to stem the flow of business activity, lending, and excessive leverage in financial markets. But in the Fed’s post QE world, a massive $2 trillion in private bank excess reserves still waits like a coil under tension, ready to release if it leaves the Federal Reserve. Thus, the only means to control this centrally created asset bubble is to continuously pay banks higher interest rates (almost like paying the mafia for protection…from the mafia) not to return those dollars to their original owners or put them to work. With each successive hike, banks are paid another quarter point to take no risk, make no loan, and just get paid billions for literally doing nothing.

The chart below shows the nearly $4.4 trillion Federal Reserve balance sheet, (acquired via QE, red line), nearly $2 trillion in private bank excess reserves (blue line), and the interest rate paid on those excess reserves (black line). While the Fed’s balance sheet has begun the process of “normalization”, declining from peak by just over a hundred billion, bank excess reserves have fallen by over $700 billion since QE ended. So what?

The difference between the Federal Reserve balance sheet and the excess reserves of private banks is simply pure monetization (the yellow line in the chart below). This is the quantity of dollars that were conjured from nothing to purchase Treasury’s and mortgage backed securities from the banks. But instead of heading to the Fed to be held as excess reserves, went in search of assets, likely leveraged 2x’s to 5x’s (resulting anywhere from $3 trillion to $7.5+ trillion in new buying power).

From world war II until 1995, equities were closely tied to the disposable personal income of the American citizens (DPI representing total annual national income remaining after all taxation is paid, blue line). However, since ’95 lower and longer interest rate cuts have induced extreme levels of leverage and debt.

The Fed actions have created progressively larger asset bubbles more divergent from disposable personal income at peak…but falling below DPI during market troughs. But after …read more



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