2019 was shaped by the Fed pivot. The Fed had anticipated three quarter point interest rate hikes in 2019, only to quickly change course early last year and ultimately cut the Fed funds rate three times between July and October to forestall a deteriorating global and U.S. growth outlook.
U.S. equities instinctively jumped more than 30% off their December 2018 lows. The reaction from the real economy and bond market, so far, has been much less dramatic.
While no longer inverted like it was last summer, the U.S. Treasury yield curve continues to signal low inflation and a sluggish real growth environment for the foreseeable future.
Meanwhile, U.S. economic growth, which started 2019 growing at a 3.1% annualized pace has settled into a GDP growth rate of just over 2.0% over the last three quarters. We receive the first estimate of Q4 GDP next Thursday, where we expect a growth rate of 2.2% annualized to close out the year.
While analysts are focused on what the Fed’s next interest rate move might be in 2020, a hike, a cut, or a hold. Next week’s January FOMC meeting outcome is expected to be a “yawn”. The Fed has signaled they will remain firmly on hold unless there is a material change to their economic or inflation outlook.
The real action in Fed monetary policy these days is the Fed balance sheet and the impact it is having on bank reserves, bank deposits, and banks’ overall willingness and ability to lend. While 2019 was about reducing risk aversion and loosening financial conditions in the financial markets, 2020 will be about loosening financial conditions and bolstering activity in the banking industry.
The Fed Balance Sheet peaked at $4.5 trillion in June 2015, but started declining in October 2017 when the Fed began its balance sheet normalization. As of September 25, 2019 the Fed Balance Sheet stood at $3.5 trillion. In July 2019, the Fed announced it was ending its balance sheet normalization two months earlier than expected – an acknowledgement from the Fed that the balance sheet runoff had compressed bank reserves and in-turn bank deposit growth and may be negatively impacting overall market liquidity.
Then it happened. In September 2019, we saw new disruption in the U.S. overnight money market as repo rates and SOFR rates briefly increased well above the Fed funds target rate to a peak of 10.0% and 5.25% on one day. The Fed even lost control of the effective Fed funds rate as it traded well above the Fed’s target at 2.3%.
This type of market rate behavior has not been seen since the financial crisis of 2017. Total U.S. bank reserves shrank in 2019, putting a strain on bank liquidity as Treasury security issuance ramps up with the U.S. budget deficit. In response, the NY Fed has held daily overnight repo operations and 14-day term repo operations through at least January to ease bank liquidity constraints. The Fed also resumed regular Treasury bill purchases of $60B per month in October and plans to continue them until Q2 2020, once again expanding its balance sheet.
The importance of the Fed’s balance sheet policy reversal on bank liquidity and credit conditions cannot be overstated. The Fed’s monetary medicine is now flooding the banking industry’s fields. Like parched farm land that can’t grow crops without irrigation, the banking industry has been short on liquidity, reducing its ability to grow loans. But recent data suggests the monetary taps are now wide open.
The Fed’s balance sheet grew to over $4.174 trillion in early January, a $674 billion increase since the end of September when monetary market rates went haywire. Bank reserve balances too have swelled to around $1.687 trillion, an increase of nearly $293 billion since their September low. This will give the banking industry new firepower to lend to consumers and businesses in the coming year.
Perhaps the clearest sign of renewed liquidity in the bank industry is the jump in total deposits at commercial banks. According to Federal Reserve data, commercial bank deposits were 7.1% above year ago levels in November and jumped 11.7% on an annualized basis. So while expectations around future Fed interest rate moves will get all the attention at next week’s FOMC meeting, it’s the Fed’s balance sheet and expected future adjustments in asset purchases and repo operations that will be much more important for the U.S. economy and markets in 2020.
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