CICC: The Fed's balance sheet expansion may not affect the market, bullish on Chinese and American stock markets, as well as gold, silver, and copper.

CICC released a research report stating that on January 30th local time, US President Trump nominated Kevin Wash to be the next chairman of the Federal Reserve, sparking concerns in the market about his remarks on balance sheet reduction. Given the strong constraints formed by the current operating rules of the US dollar liquidity system and the major fiscal trends, it is difficult for anyone chosen as Chairman of the Federal Reserve to shake the normalization of balance sheet expansion. There is a possibility of continued bull market in global assets, especially in the US and China stock markets (especially the Chinese stock market, which has been significantly under-allocated by global active funds) and gold, silver, and copper that continue to benefit from the trend of improving US dollar liquidity this year. CICC pointed out that the liquidity tightness problems arising from the tariff dispute in April last year, the government shutdown in October, and the recent crisis in Greenland have increasingly demonstrated the United States' growing fiscal financing needs and the reliance of the US financial system on the Federal Reserve's "ample liquidity" system. In the current situation of impending midterm elections, fiscal tightening and financial crises are not results that Trump wants to see. Since last year, CICC has consistently urged the Federal Reserve to stop shrinking its balance sheet and to start expansion, which was confirmed in April and at the end of the year. Although the Fed started expanding its balance sheet at the end of December last year, the marginal improvement in liquidity is still far below the lower limit of "ample levels." The US dollar liquidity quantity-price indicators still show that they are in a tight state since the outbreak of the epidemic, which CICC believes is the fundamental reason for the recent panic selling in the market. Under the pressure of debt, elections, and financial market stability, the difference in who is chosen as Chairman of the Federal Reserve may not be that significant, and the expansion of liquidity trend is likely to be a high probability event. It is difficult to shake the expansion of the balance sheet for several reasons. Since the financial crisis of 2008, the Federal Reserve's balance sheet has been on a steadily rising trend. The fundamental reason is that the Federal Reserve has established a monetary policy system based on "ample reserves." After 2008, the long-term ample liquidity and ultra-low interest rates in the market have greatly influenced the financing behavior of the financial industry. For example, the banking industry widely relies on demand deposits for financing, while the growing non-bank system (such as hedge funds) largely depends on the overnight repurchase market. Therefore, as the scale of financial activities expands, the market needs a larger scale of short-term liquidity (i.e., reserves) to maintain this system. When liquidity falls below the alert line (based on the Federal Reserve's calculation of the size of ample reserves, about 10%-11% of GDP), financial markets become prone to risks. In fact, the financial risks since 2019 have occurred when liquidity approached or fell below this warning line. Of course, this is what Wash considers a problem with QE policy. However, for this structural problem, it is difficult to "break" without causing significant turmoil. The question is, how much courage and strength do the Trump administration, the Federal Reserve, the American people, and Wall Street have to accept a "break"? After all, maintaining financial stability is also a major goal of the Federal Reserve. From historical experience, the length of the economic downturn caused by a financial crisis is often longer than that of the financial markets themselves. For example, after the subprime crisis in 2007, the recession in the US economy lasted until 2009, and the overall recovery was weak thereafter, while the financial markets themselves recovered in 2009. The real reason why the Federal Reserve cannot stop the expansion of its balance sheet is the binding of fiscal dominance on monetary policy. As mentioned earlier, the current US financial markets heavily depend on repurchase financing, and US Treasuries are the core collateral in the repurchase market. In other words, if there is no one to absorb the issuance of government bonds, the devaluation of US Treasuries will lead to a contraction in market financing and amplify the contraction effect through the collateral multiplier. Therefore, the combination of fiscal expansion with an ample liquidity system and Quantitative Tightening (QT) inherently poses a contradiction, and QT ultimately leads to the detonation of risks in the US Treasury-repurchase market, forcing the Federal Reserve to return to QE to rescue the market. The risks in the repurchase market in September 2019, the US Treasury market in March 2020, and the tariff issue in April last year, as well as the Federal Reserve's rapid turnaround in QT policy afterwards, have repeatedly proven this result. Since 2024, CICC has continued to emphasize that in the current context of domestic wealth gap issues and global geopolitical and technological competition, the possibility of US fiscal tightening is low, especially facing the midterm election pressure this year, Trump's urgency to expand fiscal policy is only increasing. Fiscal and monetary coordination under false independence Given that Wash is a chairman candidate carefully selected by Trump, CICC estimates that he will likely follow the urgent priorities of the Trump administration. Just as Miran, before being elected as an FOMC member last year, showed strict independence from the Federal Reserve, but continued to push for significant interest rate cuts after taking office, CICC expects Wash's "hawkish" stance to face pressure at the operational level. Winning the midterm elections and achieving the reshoring of manufacturing within Trump's foreseeable term is the biggest "political correctness," where monetary policy continues to cooperate with fiscal easing, balance sheet expansion (even YCC). Within this framework, Wash may simultaneously advance the deregulation of the US banking industry, such as completely lifting restrictions on MBS and US Treasury securities under SLR, to encourage market holding of bonds and relieve the Federal Reserve's predicament of being forced into QE. In the long run, achieving a transition of the US economy from virtual to real does not mean simply suppressing the US financial industry, especially in a situation where a financial crisis may have long-term and profound impacts on the real economy. Just as Bernette has been continuously urging the Federal Reserve to pay attention to vulnerable sectors such as real estate since last year, CICC expects the transition to the real economy to involve more monetary support to certain structural sectors in cooperation with fiscal policy, in order to more effectively stimulate the reshoring of manufacturing and ease the financing burden on households and small businesses. In terms of assets, CICC once again emphasizes that the expectation of dual monetary and fiscal easing this year remains unchanged. The US nominal economic cycle is expected to restart upwards, with broad US dollar liquidity supporting global risk assets and gold, silver, and copper. It is especially favorable for emerging markets (such as the Chinese stock market, which is still significantly under-allocated by global active funds) and gold, silver, and copper. At the sector level, with the support of the Federal Reserve, Trump may further accelerate the restructuring of the geopolitical landscape. The importance of security and resilience is becoming increasingly prominent, continuing to benefit productivity improvements (technology and industry) and self-sufficiency in resources. Of course, continued balance sheet expansion may further stimulate speculative behavior in financial institutions, increase market bubble risks, increase short-term market volatility (such as in gold, silver, and copper), and pose greater challenges to future monetary policy.