Is The U.S. Top Bank About To Start A Recession? - YouTube

Stock market observers are sounding an alarm.

I personally think we are right in maybe the biggest bubble of my career.

Investors have loaded up on risky assets like housing, tech stocks and even cryptocurrency.

Asset valuations are somewhat elevated, the cryptocurrencies that are really speculative assets.

I do think they are risky.

They're not backed by anything.

Many believe that the market problems started at the top U.S.

bank, the Federal Reserve.

The Fed controls all of the money in circulation that includes all of the money in your wallet and the

coffers at banks.

They can print more during financial emergencies.

Once the Fed came in, people now expect the Fed is going to come in again.

For the last two decades, the U.S.

central bank has kept interest rates on loans as cheap as possible.

They also bought bonds, flooding the market with emergency cash.

The balance of the Fed's bond portfolio has crescendoed to nearly $9 trillion, an all time

high.

What's happened is the balance sheet has become more of a tool of policy.

The Federal Reserve is using its balance sheet to drive better outcomes.

The Fed's actions led the market to historic highs, but some within the central bank believe that this bond

buying program needs to end; the sooner the better.

Analysts predict a $2-3 trillion wind down in the Fed's bond portfolio over coming years.

Doing so would stabilize markets, but there's a risk: if the Fed drops its emergency stimulus too

quickly, it could spark a recession.

The big challenge is raising interest rates enough-tightening policy enough-to corral

inflation without tipping the economy into a recession.

Easier said than done.

History is not necessarily on their side.

So how did the Fed acquire nearly $9 trillion worth of assets, and can they sell them without

breaking the economy?

The U.S. government relies on its central bank, the Federal Reserve, to manage the economy.

The Federal Reserve itself was created after a major crisis.

There was a financial crisis in 1987.

We didn't have a central bank and there was a large study done that concluded that part of what we needed

to avoid these future crises was a central bank that would be able to create more currency

during times of stress.

The Federal Reserve has proven itself repeatedly over time, well positioned to be the

first responder in the face of any type of shock.

The Fed's most important tool is the federal funds interest rate.

The Fed funds rate right now is between 0%-0.25%.

That's as low as they can go.

It was highly unusual to have interest rates close to zero.

Basically, what the Fed does is it sets the rate at which banks borrow money between themselves overnight.

Now, from that short term rate comes all the other rates that people pay for in terms of mortgage

rates or home equity line of credit rates or automobile loan rates.

But ultimately, all rates are set by banks and by the market based off of that short term

overnight rate that the Federal Reserve sets.

Central banks around the world have kept interest rates low to stimulate further growth in the face of unusual

financial conditions in the U.S., bankers have resisted using negative interest rates.

Instead, they've delivered economic stimulus with tools like the bond portfolio.

They keep track of the spending with a balance sheet.

All banks have a balance sheet.

They have assets and liabilities.

The liabilities are the currency in circulation they call Federal Reserve notes.

It's a primary liability on the asset side of the balance sheet.

Then the Federal Reserve has purchased a number of things, including government

securities, some mortgages.

It's all because you need to back those liabilities, that currency in circulation, with assets.

The Fed has the power to create more money when the financial system starts to break down.

For this reason, experts call it the "lender of last resort".

The lender of last resort was, in many ways, the original function of the Federal Reserve.

We didn't want to have a central bank originally because we were worried about there being so much power

aggregated in that way, but we needed this function and we might as well have it put in

place in a way that allows oversight and accountability

For much of its century long existence.

The Federal Reserve did not make much use of the balance sheet

On nine eleven. It was a balance sheet of roughly $750-$800

billion and that was the largest it had ever been at that point.

Dr. Ferguson left the central bank shortly before the housing crash took hold in 2008.

In that episode, nervous investors watching the real estate sector started to pull out of the entire market.

To prevent the full scale collapse of the financial system, Federal Reserve Chair Ben Bernanke authorized a

large scale purchase of bonds, sending the balance sheet rapidly upward.

The pundits called it

Quantitative easing, quantitative easing, quantitative easing, quantitative easing.

Quantitative easing was this mechanism of trying to to spur more credit creation.

And the core idea here was that by buying up safe instruments, treasuries and agency

mortgage backed securities, they could spur even more accommodative credit conditions and try to

get more economic activity.

Investors buy bonds to generate a modest but guaranteed return.

The U.S. Treasury bonds are perhaps the safest assets out there.

They're known as a risk-less asset, and most of the mortgages that the Federal Reserve is buying are what's

called conforming mortgages.

Very very deep and liquid market.

Many traditional investors recommend using a portfolio that balances these bonds against stocks.

But when the Federal Reserve steps into the market, it's taking these safe bonds.

Making profits on them fall for everyone

That is going to make it from the investor perspective more likely that they are ideally going to be

putting their capital work in ways that support private innovation.

Holding such a large balance sheet of nearly $9 trillion has contributed to

this environment, where a lot of money is flowing into risk assets.

And you started to see some crazy things companies that really don't have much of a business or able to

go the IPO route in 2020 and especially in 2021, and raise a lot of money.

Those businesses ultimately fail.

There's going to be a lot of investors kind of left holding the bag.

Markets have come to rely on the Fed's purchasing patterns,

But by making the Federal Reserve so central in the efforts to get money to

companies in the spring of 2020 and the summer of 2020, we did create an overall

environment where we did far more to backstop some really

fragile financial intermediaries.

So if you were a large company, regardless of whether you were a highly creditworthy or not so creditworthy

large company. Your ability to raise money by issuing new debt over the past couple of

years has just been astounding.

The central bank took on nontraditional assets like securitized mortgage loans.

To some, this has been controversial.

How many of you people want to pay for your neighbor's mortgage that has an extra bathroom and can't pay their

bills? Raise their hand?

How about we all, President Obama?

Are you listening?

The Federal Reserve warned markets that the time had come to wind the balance sheet down.

That sent day traders into a panic.

In the next year or sooner, we are going to end quantitative easing.

We are going to end bond buying.

We are going to end the injection of new reserves that creates the necessary money supply.

That ain't bullish for gold.

I'm sorry.

The idea that one of the biggest buyers and biggest holders of

government debt in particular and mortgage backed debt would all of a sudden stop being a buyer and

potentially start being a seller.

That caused investors to freak out, and so they quickly backpedaled from that.

And that never really even came to pass.

For several years later, they started to slowly let bonds that were maturing roll off the

balance sheet.

Over time, emotions calmed and the balance sheet plateaued.

Ben Bernanke's plan had proved successful and stock aluations were at a record high.

The central bank started to unwind the balance sheet slowly before warning signs flashed again in 2019.

Toward the end of the 2010s, strong market conditions gave the Fed enough confidence to start letting its

bonds mature.

They didn't get very far before economic growth really slowed sharply, and they once again had to

start cutting interest rates.

That was in the middle of 2019, when unemployment was at a 50 year low and nobody had ever heard of COVID.

The pandemic brought another significant round of bond buying.

The Fed again took the safe Treasury bonds and mortgage backed securities off the market.

They also set up lending facilities to buy bonds from municipalities and corporations.

That was a new thing that the Fed did this time around.

The 2020 bond purchasing program brought investors flooding back into the stock market after a sudden

collapse.

Holding such a large balance sheet of nearly $9 trillion has contributed to

this environment where a lot of money is flowing into risk assets and you started to see some

crazy things. Things like cryptocurrency or even NFTs.

I think a lot of the fervor for those has been driven by this ultra low rate environment where

the pursuit for return meant going into to risk assets.

The large cash injections boosted large corporations at the expense of smaller businesses.

The Fed just didn't have the right tools to really help out small businesses, and as we

saw with the Main Street lending facility, which was supposed to help out midsize businesses.

The Fed also didn't really have the right tools to support them.

By contrast, the largest companies in our country are much more able to raise

funds through mechanisms like issuing debt into public markets.

And this has been bought up like crazy by these open end bond funds and ETFs backed by

bonds. And what we don't want is the the complex set of machines that is the financial

systems to grind to a halt because it lacks the liquidity you don't want to to force a

recession as a result of a breakdown in the financial system.

Members of the Federal Reserve contend that these emergency asset purchases are necessary.

They believe that the debts will be paid as they mature

After almost every crisis.

There's often a survey, often a commission done or hearing, etc.

and then Congress decides how to adjust the authorities to focus on

these crises.

The resulting end of our pandemic asset purchases will remove another source of unneeded

economic stimulus for the economy.

I expect that these steps will contribute to an easing in inflation pressures in the coming months.

Certainly, some of these people on the committee are hot to begin reducing this balance sheet.

The Fed plans to unwind its asset portfolio at a more aggressive pace than what it attempted following the

housing crash.

We may find for all of us that the price of money, cost of a loan, the interest rate gradually starts

to rise from what has been historically very low levels.

I've already seen some of that.

Mortgage rates are a little bit higher now than they had been in the past.

And also the borrowing rates for corporations are somewhat higher.

The Fed will shrink its bond portfolio by $2-3 trillion in this round.

Market turbulence could follow the Fed's tightening of the economy, sparking a recession.

Are we going to go back to the Fed having a balance sheet of the size that it was in

2006 and early 2007?

They are far more skeptical.

The role of reserves on bank balance sheets has changed a lot.

It's not fair to say the balance sheet is not supposed to be used the way it's used.

It is a new tool.

What's new about it is, one, it's being used quite consistently.

Two, it's being used at a scale that was not imagined before.

But it is very public, but like lots of things in plain sight, you don't necessarily notice it.