The Federal Reserve will hold its second interest rate meeting this year in mid-March, and the market’s expectations for a rate hike at this meeting are extremely strong, which has caused the crypto market to slump. Many investors compared the Fed's rate hike to the "Air Force" big move. As long as this big move is released, the market will fall and rout.
Historically, however, the 2017 bull market came out of the Federal Reserve's successive rate hikes. If we deeply analyze the entire process of the Fed's recent rate hikes, it's not difficult to find that rate hikes are often just a "warm-up exercise", and the Fed's opening of its balance sheet is the real "big move of the Air Force".
Last Thursday, the minutes of the January FOMC meeting released by the Federal Reserve showed that many policymakers believed that the balance sheet should be reduced (shrinking) later this year. Although there is no clear answer to the questions of "when to start, how fast, and when to stop?", the crypto market fell as soon as the word "shrinking the table" was released, and it has been falling until now, and the phenomenon of accelerated decline appeared yesterday. In history, every time the Fed shrinks its balance sheet which caused a bloody storm, even catastrophic consequences.
In the third article of the Fed's interest rate hike series, let's talk about the core concept of the Fed's monetary policy: shrinking the balance sheet. And to interpret for you, why is the shrinking of the table the beginning of the plunge and the end of the bull market?
The "dark history" of the Fed's shrinking balance sheet, collapsed as soon as it shrinks?
In 2022, the Fed will mainly do three things, accelerate the reduction of the scale of bond purchases, raise interest rates, which means raising the federal interest rate, and shrink the balance sheet.
Now, the tapering of bond purchases is coming to an end, and the market has priced in the Fed's expectation that the Fed will raise interest rates several times in the future, which means that among the factors that will affect the market in the future, the shrinking of the balance sheet will be the key.
From a historical point of view, the Fed has tried to shrink its balance sheet six times in the past, in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000. Notorious nearly every time, 5 of which ended in recession.
The Fed's six shrinking of its balance sheet in its history has caused a lot of downward pressure on the economy and the market. Among them, in 1920, the Federal Reserve shrank its balance sheet 6 times, lasting 1 to 2 years, with a 15% shrinking of the balance sheet, the stock market fell, the economy declined, and inflation turned to deflation. In 1930, during the Great Depression of the United States, the passive shrinking of the balance sheet caused stocks to fall and the economy to collapse. In 1949, after the expansion of the balance sheet during World War II to support the war, the Fed voluntarily reduced its balance sheet, causing stocks to decline first and then rise. In 1969, because of the Marshall Plan, the Fed passively reduced its balance sheet, causing both stocks and the economy to be slightly impacted. From 1978 to 1979, the balance sheet was passively reduced during the second oil crisis, but it failed to curb inflation, and stocks and the economy both declined. In 2000 and 2011, after the burst of the Internet bubble and the 9/11 terrorist attack, the balance sheet was actively reduced, since this is due to the withdrawal of the Fed's short-term liquidity relief measures, the impact is not large.
The Fed's shrinking of the balance sheet has a huge impact on the world economy and investment markets, and it is basically a relatively negative impact. Specifically, the world economic growth will decline. According to World Bank data, the shrinking of the balance sheet in 1960, 1978 and 2000 had little impact on the current global economic growth, but the global economic growth declined in the following 1-2 years, the U.S. economic growth rate also declined to varying degrees during the period of the shrinking balance sheet.
From the perspective of the global flow of capital, after the Fed shrinks its balance sheet, foreign direct investment (FDI) in other countries will decline significantly. For example, in 2000, when the balance sheet was shortened, the net FDI inflows to high-income countries and low- and middle-income countries fell sharply by 47.87% and 8.55% respectively. On the contrary, the net FDI inflow to the United States has continued to grow after the balance sheet was reduced. For example, in 1978 and 2000, the foreign direct investment inflow to the United States increased by 101.72% and 11% respectively during the period of the reduction of the balance sheet. From this point of view, the Fed's shrinking of its balance sheet can be said to be wielding a reaping sickle against the world.
From the perspective of the global investment market, basically every time the balance sheet is shortened, it is dominated by a long-term decline. Except for the balance sheet reduction in 1949, the other five times of balance sheet reduction were all during or after the reduction of the balance sheet. And other investment market prices fell sharply. Judging from the most recent shrinking of the balance sheet, which started at the beginning of 2018 and lasted for one year. The US stock market and other global markets also fell for a year. Bitcoin and the entire crypto market also directly turned from bulls to bears, and fell sharply for one year. Bitcoin fell from nearly $20,000 to $3,000, a drop of more than 80%. It can be said that the Fed's balance sheet reduction cycle is almost synchronized with the decline cycle of investment markets such as the stock market, which is very worrying.
The Fed has now begun to discuss the shrinking of the balance sheet. The minutes of the January FOMC meeting released last Thursday also clearly mentioned the issue of shrinking the balance sheet. If the follow-up rate hikes 2 or 3 times have little effect, the possibility of the Fed shrinking the balance sheet ahead of schedule cannot be ruled out. . Federal Reserve Governor Waller mentioned on Friday that "the Fed can start reducing its balance sheet soon after raising interest rates." Bullard, president of the St. Louis Fed and one of the FOMC voting committee members next year, also tends to start the balance reduction as soon as possible. It can be said that the big killer of shrinking the balance sheet has been removed from the arsenal by the Federal Reserve, and it will be thrown out only when the opportunity is right.
The curse of the Fed's shrinking balance sheet, why does every shrinking of the balance sheet have catastrophic consequences?
We know that the explosion principle of the "gun-type" nuclear bomb is: the detonation controller automatically detonates the explosive, and quickly compresses the two hemispherical fissionable materials into an oblate sphere, reaching a supercritical state. The neutron source releases a large amount of neutrons, which makes the chain reaction proceed rapidly and releases a large amount of energy in a very short period of time. This is the explosion of a nuclear bomb with huge destructive power.
And analyzing the recent Fed rate hikes, we will find that in each hike cycle, at the beginning of the phase, the market remains the same. The market will truly usher in a decline until the start of the shrinking schedule, and even bring catastrophic consequences to the world: All investment markets plummet and even cause a great recession.
The Fed raising interest rates is like the "detonation explosive" of a nuclear bomb, and shrinking the balance sheet is the big explosion of the nuclear bomb. Why is it so powerful? This can be analyzed from the Fed's shrinking of the balance sheet itself and the reasons.
The Fed’s shrinking of its balance sheet is simply an act of reducing the size of its own balance sheet. The Fed can directly recover the base currency by directly selling its holdings of bonds or stopping the reinvestment of matured bonds, which is more severe austerity policy than raising interest rates. The shrinking balance sheet can be called a "nuclear weapon" in the Federal Reserve's ammunition arsenal, which means to officially announce to the world that the United States' comprehensive tightening monetary policy has begun to arrive.
The Fed launched an unrestricted bond-buying program in early 2020 due to the impact of the epidemic to boost markets and reduce long-term borrowing costs for businesses and households. So far, the Fed's balance sheet has reached $9 trillion, more than double its previous size. These massive balance sheets consist primarily of U.S. treasuries and MBS securities.
U.S. Treasury bonds are issued by the U.S. Treasury. After the Federal Reserve buys U.S. Treasury bonds, all money flow to the Treasury Department, and then the government "issues money"; MBS securities are mortgage-backed bonds, that is, collect the loans that meet certain conditions in the loaned housing mortgage loans to form a collection of mortgage loans, which means the Fed has taken all the blame for real estate liabilities. The former channel is to increase the cash flow of US dollars by issuing treasury bonds, and the latter channel is to increase the cash flow by lending. The meaning of shrinking the balance sheet can be simply understood as the Fed not only stopped buying bonds, but also began to sell bonds to recover dollars.
An important follow-up task for the Federal Reserve is to quickly deal with the 9 trillion US dollar balance sheet, recover the US dollar after selling it. It may fundamentally drain the "water" in the market, which will dry up almost all markets, including the crypto market, and all creatures in the market will face the threat of death.
Judging from the reasons for the Fed's shrinking of its balance sheet, continued interest rate hikes may not necessarily push up long-term interest rates. Instead of curbing inflation, it may lead to a flattening or even inversion of the yield curve. In other words, the traditional monetary policy transmission mechanism has weakened. The scale reduction is a quantitative tool. If the overheating economy cannot be suppressed by "raising prices", then "reducing the volume" will be a more direct choice.
Because the inflation this time was caused by the large release of water by the central bank represented by the Fed, that is, the excess issuance of "exogenous currency", the Fed's previous substantial expansion of its balance sheet has flooded the market with liquidity, and it is now difficult to adjust the currency supply by adjusting prices (interest rate hikes), and a more direct way to control the money supply is to reduce the amount, that is, to reduce the size of the balance sheet. That is to say, this round of Fed rate hikes may not achieve the expected effect, and the shrinking of the balance sheet will be the final measure, or it may be a means to have a more severe impact on the market.
Therefore, what really scares people this year is not the Fed raising interest rates, but the Fed starting to shrink the size of its balance sheet which is the ultimate killer, also the nuclear bomb of the "Air Force".
In conclusion, 2022 may be the year of full-scale tightening, and if the Fed starts raising interest rates and shrinking its balance sheet, we will enter a period of double tightening. Compared with shrinking the balance sheet, raising interest rates is not regarded as recovering liquidity. If interest rate cuts and QE are compared to stepping on the accelerator, then raising interest rates is equivalent to releasing the accelerator, and the speed of the vehicle will gradually slow down. And shrinking balance sheet is the real direct brake. When you step on the brakes, all the people and objects in the car will stop passively, and even be hit with blood because of inertia.
Although from the past practice of the Fed, it has entered a period of interest rate hike cycle first, and then began to shrink its balance sheet. However, this time due to the high inflation and economic systemic risks caused by the outbreak of the epidemic, the Fed is likely to shrink its balance sheet ahead of schedule. Compared with raising interest rates, shrinking the balance sheet is the real nuclear bomb explosion, and the impact on the crypto market may be a disaster, and it needs to be paid attention to.