A weak dollar could solve the Fed’s problem of shrinking its balance sheet without disrupting global markets. “Contradictory statements by Fed officials and poor demand at recent treasury auctions betray a sense of nervousness surrounding the issue of normalization,” says Vincent Deluard, head of global macro strategy at INTL FCStone. “It needs not be, for the solution is simple: just have foreigners replace the Fed’s purchases.”
Deluard thinks that fears of balance sheet normalization leading to a stampede in the Treasury market are wrong. But it all depends on the U.S. dollar. If it keeps depreciating, foreign central banks will replace the Fed’s purchases by buying Treasuries as they always do. Such is the beauty of being the world’s main reserve currency.
If Deluard is right, and if the dollar does weaken (helped today by OPEC cuts), then there is hope for fixed income investors. Balance sheet normalization is also a more flexible tool than rate hikes during times of political uncertainty.
Some things worth noting, as taken from a report by Deluard on Wednesday:
- Based on official statements, the Fed should normalize its balance sheet by early 2018
- Balance sheet normalization would coincide with a $560 billion maturity cliff and surging deficits
- Weak demand at recent Treasury auction indicate concern about a supply/demand mismatch
- A weak dollar could solve the Fed’s problem: foreign central banks reserve accumulation would replace the Federal Reserve’s re-investments
- Balance sheet normalization would give the Fed tools to fight the next recession without causing market havoc and economic headwinds
- In a context of extreme political uncertainty, favoring normalization over rate hikes would be the most prudent course of action.
“Finding buyers of U.S. Treasuries is easy,” says Deluard, referring to its status as reserve currency.
Between 2002 and 2012, major foreign holders of Treasuries increased their holdings by $4.3 trillion, or $434 billion annually. That is precisely the amount needed to meet that infamous “maturity cliff” yet again in 2018.