The reduction in the Federal Reserve’s balance sheet, which will begin in October according to last week’s Fed release, is “a nonissue for the economy and could prove positive for financial markets, and banks in particular,” according to Michael Grant, Senior Co-Portfolio Manager of the Calamos Phineus Long/Short Fund (CPLIX).
The Fed has decided to gradually reduce its purchasing of fixed income securities in the secondary markets, primarily from banks, which implies that the banks’ total reserves parked at the Fed will now start to decline.
When the Fed purchased bonds from banks as part of its quantitative easing (QE) program, it paid for them with newly credited money by crediting the reserves that banks maintain at the Fed. The banks must now decide whether they will replace the Fed as the buyer and holder of these securities, which implies replacing their reserves at the Fed with U.S. Treasuries at the Fed.
“If they do,” says Grant, “the impact of a smaller Fed balance sheet could be negligible. In terms of its capital requirements, the banking sector achieves as much from a dollar of reserves as a dollar of U.S. Treasuries at the Fed.”
According to Grant, banks will earn more from their new assets at the Fed than what they had been earning on their reserves. This should boost margins, which is why banks are incentivized to shift their composition of “high quality liquid assets” for capital calculations, thereby replacing the Fed as the buyer of Treasuries.
Grant dismisses suggestions that the move will be disruptive. “I think there should be very, very little, if any, negative impact at all on the banking system and thus the economy,” he says.
Consider the Interest Rate Environment
And, he adds, today’s U.S. interest rate environment should be considered in the context of what’s happened globally.
“While it’s true that the Fed’s balance sheet will be shrinking, the European Central Bank balance sheet and the Bank of Japan balance sheet are still growing. So, if you look at those balance sheets in aggregate, even with the Fed reducing the size of its balance sheet, the aggregate balance sheets at the major central banks will continue to rise at least into late 2018.”
To prove the point, Grant points to the 30% year-over-year growth of European balance sheets. Japan’s balance sheet year over year is up about 10%.
“Globally,” Grant says, “this is not a case of liquidity now being reduced. Rather, it’s a case of liquidity not increasing as much as it has in recent years.”
“The key point,” he says, “is that the Fed’s balance sheet reduction is not symmetrical to the initial balance sheet surge that began with QE in 2012. And the reason is that the state of the U.S. economy and banking system today is dramatically different.”
“In 2012,” he continues, “the U.S. economy was caught in a liquidity trap, which affected how capital flowed through the banking system and thus, the impact of QE on the lending cycle. That is not the case today. Capital flows related to balance sheet reduction could be much more pro-cyclical because the U.S. economy has found its footing.”
What Is The Fed Trying to Do?
It’s more important to understand what the Fed is trying to do, says Grant. Like most policymakers, the Fed is acutely aware of how the “unfair distribution of economic growth post-crisis” has contributed to U.S. political tensions.
“I often see language like ‘The Fed is trying to raise rates and slow growth.’ I don’t believe that’s the case at all. I think the Fed’s objective is to make this the longest expansion on record, and it has a very good chance of achieving that.
“What the Fed doesn’t want is an economy that gets too strong in the short term, forcing it to raise rates more aggressively, ending in a harder downturn 18 months from now.” Grant believes the Fed wants a modestly growing economy of 2% to 2.5%, with the flexibility of moving slowly on interest rates.
“The Fed does not disabuse markets of the concern that balance sheet shrinkage could weigh on economic growth, but I suspect that is politically motivated,” says Grant. In his view, balance sheet reduction gives the Fed political cover for moving more slowly.
Ultimately, all things considered, balance sheet reduction could be good for the financials sector, which Grant’s CPLIX has significant exposure to.
The portfolio team continue to be positive on financials. After years when the mix of de-leveraging, higher capital requirements and excess regulation proved headwinds for the industry, all of these factors have reversed and will now act as powerful tailwinds, says Grant.
“Financials, as a sector, remains well valued and has the highest earnings yield in the US market. Into 2017, it has enjoyed one of the fastest growth rates as well, both for revenue and earnings.”
The top sector for year-over-year growth is typically U.S. technology, but the growth is driven by a handful of well known companies like Facebook, Amazon and Google. Beyond those platform leaders, the growth for the rest of tech is “more muted.”
“The underlying fundamentals for financials have been coming through in 2017 and I think they will continue for at least several years,” Grant concludes.
The fund has a diverse positioning in financials, including money center, higher quality banks (but generally avoiding regionals), asset management companies, brokers and niche lenders. The fund profile provides a listing of all holdings at 6/30/17.
Advisors, for more about Michael Grant or CPLIX, please talk to your Calamos Investment Consultant at 888-571-2567 or firstname.lastname@example.org.And for additional perspectives on the Fed move, see statements made last week by Calamos Co-CIO and Head of Fixed Income Strategies Matt Freund (here and here). Freund makes the point that the Fed’s guidance is “a ceiling, not a floor,” and will likely lead to a gradual and predictable normalization of the market. To date, he notes, financial conditions have actually loosened since the Fed began its tightening cycle. Reacting to another piece of the Fed statement, Freund expressed skepticism about the projection of four interest rate hikes next year. The tightening may be slower and more gradual, he believes.