In my last note we walked through Jerome Powell’s recent FOMC press conference.
The departing Fed Chair was again silent on the balance sheet expansion (for a third consecutive press conference). Meanwhile, they’ve added $170 billion worth of Treasuries since December.
And remember, Powell said in December the expansion would continue “indefinitely.”
Conversely, Kevin Warsh, the incoming Chair, has said publicly the balance sheet needs to shrink.
So, the path of the Warsh-led Fed has been telegraphed. And it’s eleven days away.
As we’ve said often in the post-GFC era of Fed asset purchases (balance sheet expansion) — the resulting liquidity injection tends to make stocks go up.
With that, will stopping and reversing on the balance sheet prick the exuberance of the stock market?
To front-run this debate, Stephen Miran (Trump’s appointed Fed Governor) delivered a speech in late March at the Economic Club of Miami.
He told us how they are positioning this balance sheet regime change.
In this speech (see it here) Miran reframes the entire “reserve scarcity” problem, tying it to bank regulation.
He notes that the “ample reserves” framework Powell uses to justify indefinite balance sheet expansion is not a natural feature of the system. It’s a function of Dodd-Frank and Basel.
Specifically, the liquidity coverage ratio requirements force banks to hold large reserve balances. The internal liquidity stress test standards do the same. Banks are not holding $3 trillion in reserves because they want to. They are holding it because the regulators require it.
So the demand for reserves is dictated by regulation, and that’s the lever the Trump administration intends to pull.
The first item on Miran’s list of paths forward is to ease the liquidity coverage ratio and the internal liquidity stress test standards.
Lower the regulatory demand for reserves.
Then the balance sheet can come down without creating the scarcity that would pressure short-term rates higher and break the funding markets.
Then, as an offset to shrinking the balance sheet, they will lower rates.
So the playbook is deregulate the demand side for reserves, shrink the balance sheet passively, pair it with rate cuts.
What does that mean for markets?
Lower policy rates are a tailwind for equities. The Fed exits the government financing business, which lowers the fiscal profligacy premium embedded in long Treasury yields for the past fifteen years.
Less distortion. More efficient capital allocation.
And the regulatory relief on banks frees up bank lending capacity that has been constrained since 2010. U.S. banks specifically benefit. The economy benefits as the liquidity that’s been trapped in banks becomes loans to consumers and businesses.
This is structurally pro-growth, pro-equity, and pro-credit.
The conventional view is that Warsh’s balance sheet reduction threatens markets. The Miran framing makes the case for structural reform/structural strength — which should be good for stocks, good for the dollar and dollar assets.
