One Man’s Opinion: Will US Equities Rise As The Budget Deficit Shrinks?

The Federal Reserve balance sheet has nearly tripled in size to $3 trillion over the last few years, which is a cause for concern, says David Kelly, chief market strategist at JP Morgan Funds.

The US Fed has loaded up their balance sheet with a pile of very bad assets, i.e. very low yielding bonds, and eventually they have to pay realistic rates on reserves. Few years from now, markets will wonder if the Federal Reserve can make any income at all and it might run this at a net loss, he noted. The Federal Reserve is not helping the economy a lot right now, but it is creating itself a problem for the future by building this balance sheet, David added.

Asked to explain how central banks like the US Fed manage to build balance sheets as large as $3 trillion, David said central banks are special banks since they can print money. All they need to do is print fresh notes and use them to buy sovereign bonds. The bonds are the assets (since they generate income) and the newly printed notes are part of liabilities.

The central banks can, in theory, build balance sheets of any size, he mentioned. But as Milton Friedman had noted that there are consequences to everything, there will be consequences for the Federal Reserve as well for this extraordinarily aggressive policy of building its balance sheet.

In the long run, the mismatch between the valuation of its assets and the interest it’s going to have to pay on reserves will put them in a very difficult situation, he noted. This may a side issue right now, but in the long run the Fed may lose its ability to control inflation because it has built its balance sheet this way, he added.

Asked to explain “long run”, David said from the monetary-policy viewpoint, a long-run starts when full employment is hit and wages start to increase. If the economy manages to accelerate a bit, by 2015 unemployment rate could be somewhere in the sixes and then wages could start to rise.

That will be an appropriate time for the Federal Reserve to raise the Federal Funds Rate (the rate at which banks lend excess reserve to each other overnight) to 4-5 percent. The problem is in order to lock the extra money in the banking system, known as the “excess reserve,” the Fed parks up cash and pays banks interests on the excess reserve, which is essentially the Federal Funds Rate (FFR).

If FFR rises to four percent, based on the current size of the balance sheet, the Fed will have to pay $100 billion in interests every year. If the FFR rises to six percent, the interest expense will rise to $150 billion annually, David noted. The point is there is no free lunch and the Fed may run this (business of expanding its balance sheet) at a loss down the road, he added.

Asked to explain his investment strategy in such a situation, David said the key thing is not the US Fed, but the mismatch between tail risks and tail opportunities. The tail risks have been reduced as the budget deficit has been trimmed to 5-1/2 percent of GDP this year. The deficit was 10 percent of GDP a few years ago and the economy has made progress on the deficit issue.

As the tail risk of a fiscal blowout diminishes, stocks become valuable because otherwise tail risks tend to suppress value of stocks. Given the low current interest rate regime, stocks are still cheap and investors should be overweight in stocks and underweight in fixed income, David noted.

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Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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