Staging the QE exit

Fed officials are hinting that the rate hike could take place before the Fed ends the policy of reinvesting securities that pay down or mature. The order of events would look something like this:

1. Securities purchases end later this year but the Fed maintains its balance sheet at constant level.
2. The rate hike takes place (some time in 2015)
3. The Fed begins to allow securities to mature (or amortize for MBS) without replacing the declining notional.

William Dudley: - ... it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.

Fed officials are afraid that if the balance sheet begins to naturally decline, the markets will interpret this as additional tightening. But once again, by delaying step 3, the Fed introduces incremental uncertainty. The markets and the media will be buzzing with "when does the reinvestment policy end?" question. The reality is that this delay will have a minimal impact on the trajectory of the massive balances at the central bank.

Here is a situation in which the policy itself will have no material impact on anything except that it introduces more uncertainty - something the US economy doesn't need. The Fed should just finish the QE program, stop buying any more securities, and focus on normalizing rates. Staging this process is a bit like ripping off the bandaid slowly rather than getting it over with, particularly when the bandaid is no longer of much use.

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From our sponsor:

Is China "trading" treasuries?

China reduced its holdings of treasuries in December by the largest amount since 2011, raising some eyebrows among economists and debt investors. The sentiment among analysts is that this reduction is related to Fed's taper, which of course doesn't bode well for treasuries in the near-term.

Bloomberg: - “The Chinese move to sell suggests central banks are becoming more wary of taking duration risk now with the Federal Reserve firmly into the tapering process,” said Aaron Kohli, an interest-rate strategist ... at BNP Paribas ... “If China continues to sell again in the next month or two, than more worries will arise as to who will buy the country’s debt.”

What's interesting however is that China's treasury position "adjustments" throughout last year seem to follow treasury prices (inverse of yields). This is akin to a retail investor buying high and selling low - chasing the market with everyone else. While analysts often assign some degree of sophistication to China's investment strategy, the positioning in the chart below resembles a fairly incompetent trading behavior, an unsuccessful attempt to "time" the market.

Source: The US Treasury

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The Fed now holds more securities than all US banks combined

As discussed previously (see post), US commercial banks have been scaling back on their loan portfolio growth. Banks have been even more aggressive however in reducing growth of their securities holdings. The year-over-year growth is at the lowest level since the financial crisis. The reasons vary. In some cases it was simply about trimming treasuries and MBS holdings as rates rose sharply this summer. In other cases, such as with corporate bonds, it is due to the various regulatory pressures, e.g. the Volcker Rule.

And while banks are cutting their securities inventory, the Fed keeps buying. Recently the Fed' holdings of securities (mostly treasuries and MBS) materially exceeded that of all US banks combined. Prior to the financial crisis banks owned 2.5 times the amount of securities held by the Fed. The chart below puts it in perspective. Before the securities buying program is over however, the differential is expected to widen even further.

Securities held by US commercial banks; Securities held by the Fed

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From our sponsor:

Charles Evans got his inflation wish. Taper is on.

As discussed earlier (see post), the Chicago Fed President Charles Evans and other senior Fed officials have been looking for indications that the unusually low PCE inflation rate (see post) is in fact temporary. The Fed is concerned about "turning Japanese" - a deflationary environment that is extremely difficult to correct.

It seems that Charles Evans got his wish. The Fed is just as focused on inflation expectations as on the actual inflation measures that tend to be "backward looking". And according to the Fed's own measure of inflation expectations (breakeven measure adjusted for "risk premium"), inflation expectations have risen. The August numbers were released today.

Source: Cleveland Fed

In fact the increase has been across the curve, with the near-term expectations rising the most.

Source: Cleveland Fed

This means that the last potential obstacle to the tapering of the Fed's securities purchases has been removed. The FOMC members can sleep well at night knowing that they are not causing deflation (for now) by taking this action.

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From our sponsor:

Chart: QE3 is ineffective in growing credit in the US

Based on the data from the Federal Reserve Bank of St. Louis here is a single chart that shows credit growth in the US is continuing to decline while the Fed's balance sheet is expanding.

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Funding securities purchases with reserves

We've received numerous e-mails regarding the comment (here) that the Fed (or any other central bank for that matter) finances securities purchases with reserves. It's unfortunate that the internet is full of misinformation, propagated by both bloggers and the mass media. The Fed's operations are not a mystery - it's just basic accounting. And the fundamentals of accounting tell us that if you increase your assets by purchasing something, your liabilities increase as well. The balance sheet "has to balance".

When the Fed buys a security, any of the following could be taking place:

1. The Fed sells another security in the same amount (such as in Operation Twist).
2. The Fed can lend that security via repo. In this situation the increase in assets (security purchase) corresponds to increase in liability (the Fed borrows cash against the bond).
3. The Fed can accept time deposits (now it owes money on the deposit - thus increases its liability).
4. The Fed can in effect use the proceeds from the repayment of various emergency facilities to cover the purchase. This was the case during part of QE1 (see discussion from 2009).
5. The Fed can increase bank reserves (by simply crediting the seller's reserve account). Remember that reserves are liabilities on the Fed's balance sheet.

These are all different ways the Fed can finance securities purchases. Only number 5 represents outright quantitative easing. Unless 1-4 are involved, reserves are used to fund balance sheet expansion.

There are some silly notions about what banks can and can not do with their reserve balances. Keep in mind that cash is fungible. A bank can buy securities or loans from another bank and get rid of its excess reserves - thus converting reserves into other assets. Of course then the seller bank will be stuck with these excess reserves. Only the Fed can change the total reserve balance in the banking system as a whole by buying and selling securities or by borrowing and lending money.

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JPMorgan: don't confuse dovish comments on rates with "tapering"

This was the gist of Bernanke's statement on July 10th.

MNI: - "We've said that we will not raise interest rates at least until unemployment hits 6.5% as long as inflation is well behaved," but, he stressed, "again, as I've said before, that 6.5% is a threshold not a trigger. There will not be an automatic increase in interest rates when unemployment hits 6.5%."

Rather, Bernanke said, "given weakness in the labor market - the fact the unemployment rate probably understates the weakness of the labor market - and given where inflation is, I would suspect it may be well some time after we hit 6.5% before rates reach any significant level.

"So again, the overall message is accommodation," the central banker said. "There is some prospective, gradual, possible change in the mix of instruments - but that shouldn't be confused with the overall thrush of the policy, which is highly accommodative.

Even though the Q&A came across quite dovish, JPMorgan's analysts are convinced that the Chairman was referring to the Fed Funds target rate only. The Fed is giving itself room to keep the overnight rates low even if the unemployment rate dips below 6.5%. When it comes to securities purchases on the other hand, according to JPMorgan, the pace of purchases will begin declining after the September FOMC meeting.

JPMorgan: - We heard those comments as dovish on the outlook for interest rates, but doing little to counter the notion that tapering will occur relatively soon. In some ways his comments echoed those from earlier in summer and spring: distinguishing the asset purchase policy from the zero rate policy, and emphasizing that decisions on one policy won’t necessarily impact decisions on the other policy. However, this week his remarks went further, by laying out the reasons why rates won’t rise dramatically in the medium term.
...
Nothing in this week’s developments led us to question our view that tapering in September is coming, conditional on the data cooperating.

Here is JPMorgan's forecast for the Fed's securities purchases over the next 12 months.

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From our sponsor:

The Fed's latest dilemma

The Fed continues to be divided over the next steps for its unprecedented monetary expansion program. Varying interpretations and conflicting headlines in the press leave the public bewildered and frustrated. The following two stories for example have appeared right next to one another on Bloomberg today.

But now the Fed has a new problem. The central bank's securities purchases are financed with bank reserves, which have been rising steadily in 2013 (chart below).

Source: FRB

And to many on the Fed that was justifiable as long as US commercial banks continued to expand their balance sheets. But recently that expansion has stalled.

Source: FRB

To some this calls into question the effectiveness of the whole program, since the transmission from reserves into credit is so weak. The Fed is now facing the following choices:
1. slow the purchases and run the risk of shrinking credit and rising interest rates or
2. continue with the program and risk QE "side effects" without the needed credit expansion (which has stalled).

That's why we are likely to see the Fed even more divided going forward, adding to more uncertainty and frustration by investors (including those outside the US) as well as the public.

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From our sponsor:

Shape of the yield curve adjustment impacted by bond buying pattern

Here is how the treasury curve shifted over the past two months (through today).

The obvious question is why has the sell-off been most acute in the 7-10yr range (the 7-year yield has increased by 90bp)? And why have the bonds in the 20-year range been a bit more stable. The answer has to do with the Fed's buying patterns.

Source: NY Fed

Maturities where the Fed has been most active are the ones which are more vulnerable to this correction. Those are the bonds whose prices the Fed has been supporting (aside from treasury bills that are now used as safe-haven). As the support diminishes, the bond pricing adjusts to post-QE levels. (Note that the bucketing used by the Fed doesn't match the bond maturities in the first chart precisely and the pattern is obviously not exact - yet the relationship is still visible). This tells us that a great deal of the fixed income pricing to date has been determined by the monetary expansion rather than the fundamentals of the markets.

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How did we get here? A "map" of the Fed's balance sheet's history

Some in the mass media continue to be confused about the historical trajectory of the Fed's balance sheet. People have trouble distinguishing between the liquidity facilities provided by the central bank and the various monetary expansion activities. Here is a historical "map" to show how we got here.

Fed's balance sheet (Source: FRB; click to expand)

1. The Fed launches the Term Auction Facility (TAF) to replace term interbank funding and commercial paper for banks who started having trouble rolling short-term debt. The Central Bank Liquidity Swap Facility was also launched at the time to provide dollars to other central banks.

2. Increase in TAF demand (it's no longer taboo to use the facility) and increase in the Central Bank Liquidity Swap Facility as foreign banks start having trouble raising dollars to fund their dollar assets.

3. The Fed provides Bear Stearns (Maiden Lane) funding to support the purchase of Bear by JPMorgan.

4. All hell breaks loose as the Fed is forced to ramp up TAF and the Central Bank Liquidity Swap Facility (as foreign banks desperately need dollars). The Fed also launches the Commercial Paper Funding Facility (CPFF). Among other reasons, CPFF was meant to help corporations like GE Capital, who relied heavily on commercial paper funding and were beginning to have trouble rolling debt.

5. Around the same time as #4, AIG failed. The Fed responded with Maiden Lane II (see post), Maiden Lane III (see post), as well as direct funding for AIG. This was the one move by the central bank that made Bernanke especially angry.

6. QE1 (treasuries and agency MBS). Shortly after, the TALF program was launched (relatively small impact to the balance sheet).

7. QE2 (treasuries).

8. Central Bank Liquidity Swap Facility facility picks up again as the various Eurozone banks lose their ability to roll dollar commercial paper (US money market funds cut exposure) - see posts here and here.

9. QE3 (treasuries and agency MBS).

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What would the Fed's policy "step down" look like?

A number of economists are trying to read into the meaning of Bernanke's statement last week. The comment that put a damper on the relentless equities rally and sent prices of treasuries lower. In particular the comment "we could take a step down in our pace of purchases" at the next FOMC meeting is causing angst in the investor community (see post).

But what would such "tapering" in monetary expansion look like? The most likely outcome is a shift from $85 billion of purchases a month to something closer to $60 billion. Here is the impact such a policy would have on the central bank's portfolio of securities.

The Fed is unlikely to do anything more dramatic, given the central bank has bet its reputation on this program. Reducing monetary expansion sharply just to return to it later will clearly be problematic. The outright holdings will therefore comfortably go above $3.5 trillion by the end of the year in spite of this policy pace "step down".

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From our sponsor:

Fed's balance sheet grows above $3 trillion, finally impacting the monetary base

Total assets of Fed's balance sheet broke through $3 trillion last week, hitting a new high, as securities purchases are stepped up (including treasuries).

Fed's balance sheet as of 1/16/13 (source: FRB)

And for the first time since this program was launched it is starting to have a material impact on bank reserves (the dynamic component of the monetary base), which spiked last week.

Reserve balances with Federal Reserve Banks (source: FRB)

As discussed earlier (see post), 2013 will look quite different from last year. The monetary base will be expanded dramatically as long as the current securities purchases program is in place. "Money printing" is in now full swing.

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From our sponsor:

Treasury yields capped by public sector purchases

Treasury yields have risen at the start of the new year but have since stalled. 1.9% yield seems to be the ceiling on the 10-year note for now.

10y treasury yield (Bloomberg)

Public sector entities continue to make it difficult for investors to short treasuries. The Fed's securities holdings hit a new record last week as the central bank began purchasing treasuries outright.

Outright securities holdings by the Fed (source: FRB)

But public sector treasury purchases are not limited to the Fed. Japan's new government wants to pull the nation out of the recession by devaluing the yen. The approach is two-fold: a massive quantitative easing program (see discussion) as well as direct market intervention. The market action by Japan's government involves selling the yen, buying dollars, and locking up the position in treasuries.

Bloomberg: - Abe’s Liberal Democratic Party pledged to consider a fund to buy foreign securities that may amount to 50 trillion yen ($558 billion) according to Nomura Securities Co. and Kazumasa Iwata, a former Bank of Japan deputy governor. JPMorgan Securities Japan Co. says the total may be double that. The purchases would further weaken a currency that has depreciated 12 percent in four months as the nation suffers through its third recession since 2008.

The risk to treasuries in the longer term is that the Fed may pull the plug on asset purchases earlier than investors anticipate (see Bloomberg story). For now however the yield increases will be limited.

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From our sponsor:

DE central banks' balance sheets approaching $6 trillion; expected to grow another $1 trillion in 2013

This is a well covered subject, but it's worth taking a quick look at the combined balance sheets of the developed economies' (DE) central banks. We are quickly approaching six trillion dollars.

Source: ISI group

It is important to note that not all of this would qualify as "QE". For example the Fed expanded balance sheet in 2012 without materially impacting either the bank reserves or the monetary base (see discussion). Although it was unintentional, the Fed effectively "sterilized" its purchases. The ECB also views some of its programs as sterilized.

Nevertheless it is expected that the developed nations' central banks will expand their balance sheets by another 1 trillion dollars in 2013. This will be driven mostly by the Fed and the BOJ (see discussion). And unlike last year, the US monetary base will grow sharply in 2013 (and so will Japan's). Central banks continue to feed the markets' addiction to stimulus (see discussion).

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From our sponsor:

Bank reserves still down on the year; should ramp up shortly

Some MBS settlements have now been reflected on the Fed's balance sheet, as agency paper holdings increase.

Bank reserves are also gradually moving up, though still down for the year. So far the growth in reserves has been underwhelming.

Bank reserves (soucre: FRB)

With the newly announced treasury purchases, this should pick up steam. And the settlement schedule will be much less "lumpy" than agency MBS.

One thing worth mentioning here is that the US treasury will be borrowing $45bn a month effectively interest free. That's because the Fed passes interest income back to the Treasury (less its own expenses) via earnings distribution once a year. This certainly helps reduce pressure on Washington to cut spending quickly - the can will be kicked down the road once more.

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From our sponsor:

Precious metals hit by the Evans’ Rule

There seems to be a great deal of confusion about why gold (and silver) sold off in response to yesterday's announcement from the Fed.

Source: Barchart

The Fed will be undertaking an even more aggressive expansionary policy than originally announced in September. Balance sheet will expand dramatically and so will the reserves and the monetary base. Treasuries sold off again today with higher inflation expectations (see discussion).

Dow Jones Credit Suisse 30-Year Inflation Breakeven Index (source: S&P)

So what's up with gold?

Clearly there is no single explanation. But the main thrust of the selling has to do with the introduction of the Evans’ Rule. Now that the end of this ultra-accommodative policy is linked to the unemployment rate, some gold investors are beginning to think the date is much closer than people had originally anticipated (as discussed here). The Fed has been known to be "behind the curve" and investors were betting the Fed will "overshoot" as usual (maintaining the policy of zero rates and extreme liquidity for much longer than necessary.) But with the Evans’ Rule in place, some funds involved in precious metals (including silver - silver March futures are down 3.5% today) think the exit is now much closer - simply because now the Fed will effectively be "forced" to exit based on their own rule.

Reuters: - Gold fell 1 percent on Thursday as fears the Federal Reserve might withdraw its economic stimulus if the job market improved dramatically prompted funds to reduce their bullish bets.

The metal fell below $1,700 on Thursday for the first time this week on economic worries about the U.S. "fiscal cliff," overshadowing its safe-haven appeal. Liquidation by large institutional investors in gold futures on fears of tax hikes in the new year also pressured prices, traders said. Silver dropped 3 percent for its biggest one-day decline in a month.

Gold's drop came a day after the U.S. central bank adopted numerical thresholds for its monetary policy. It said it would keep interest rates near zero until the U.S. unemployment rate fell to 6.5 percent.

Analysts said the move stirred fears that the U.S. central bank could put an end to its loose monetary policy which has boosted the metal's inflation-hedge appeal.

"With the economy showing some signs of recovery, we may see a 6.5 percent unemployment rate sooner than previously anticipated, so longer-dated funds that are heavily invested in metals are looking to reduce their gold positions," said Phillip Streible, senior commodities broker at futures brokerage R.J. O'Brien.

This effect is visible in the currency markets. The dollar index initially sold off after the treasury purchases announcement, but then recovered as soon as the Evans’ Rule was brought up. And dollar's stability is a negative for precious metals - even if inflation expectations are picking up steam again.

Dollar Index (DXY) futures (source: Barchart)

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From our sponsor:

Fed's MBS purchases settlement schedule

Per David Schawel's suggestion, here is the the settlement schedule for the Fed's MBS purchases since late August. It's quite "lumpy". Assuming nothing changes, we should see a $129bn increase in the Fed's balance sheet due to these settlements. Of course there will be more purchases as well as paydowns of existing securities this month.

Source: NY Fed

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Some securities purchases but no QE from the Fed yet

The Fed's latest securities purchases are still not having much of an impact on bank reserves (see discussion). The net effect of Fed's recent activities is equivalent to sterilization, although this is probably not what the central bank had intended. The result is similar to the ECB's SMP (Securities Markets Programme), which was (usually) sterilized by auctioning off term deposits (securities purchases increase reserves, while term deposits "drain" them).

$bn; Source: FRB

Without the increase in bank reserves, the US monetary base has been stable (unlike during previous balance sheet expansion programs). So far the Fed's securities purchases have not translated into quantitative easing (no "money printing" just yet).

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The Fed is cutting a tree with a hammer: Goldman projects $2trn of additional asset purchases through 2015

Given that the Fed's current expansionary policy is expected to have only a limited effect on US labor markets, the program may end up being in place for years. That's because slow growth will be met with additional asset purchases that become increasingly less effective over time. Here are some reasons for the program's ineffectiveness as applied to the current environment:

1. It is not clear what impact asset purchases will have on consumer confidence.
2. We've had extraordinarily low interest rates for quite some time now, yet improvements in job growth have been limited.
3. Lowering mortgage rates from 3.5% to 3% is not going to have a significant impact on home affordability or materially reduce consumers' interest expense (see this discussion).
4. Raising bank excess reserves is not going to accelerate credit expansion.
5. Fed's unemployment targets are unrealistic - it's going to be an exercise in "squeezing blood from a stone" (see discussion).
6. US real median household income has basically been unchanged since 1994. The Fed' program is unlikely to improve this metric and could actually impair incomes further by elevating inflation levels.
7. The market "euphoria" effect is fleeting.

Central bank balance sheet expansion is a blunt instrument that is simply inappropriate for addressing economic issues the US currently faces. QE is good for dealing with frozen credit markets (such as in 2008) or lowering interest rates. In the current environment however it's the equivalent of using a hammer to chop down a tree - one would need a very large hammer and a great deal of time (to drive this point we include a video of someone actually attempting to do such a thing.) The hammer here is the $2trn increase in Fed's balance sheet and the timeline extends into 2015. In the mean time one can do some "unintended" damage.

GS: - Our analysis suggests that the Fed’s asset purchases work mostly through the stock of announced purchases and only to a lesser degree through the week-to-week flow of actual transactions. This is consistent with the observed impact on bond yields around or in advance of announcement days. It also means that the impact from a cessation of purchases on the level of bond yields and financial conditions should be minor, so long as this cessation does not come as a surprise to the market. While no explicit “stock” of purchases has been announced under QE3 given the open-ended nature of the program, the Fed’s published economic forecasts suggest QE3 would run through mid-2014 and total $1.2trn. Our own less upbeat economic forecasts suggest that QE3 should run through mid-2015 and total just under $2trn.

Source: GS

This is the Fed trying to improve US labor markets:

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Fed's selling volatility into the market will force mispricing of risk

Credit Suisse has made an important point with respect to the Fed's purchases of MBS. As we know, a mortgage borrower is long an option to prepay. That means a mortgage lender is short this same prepayment option. Therefore a buyer of MBS is an options seller and the Fed is in effect selling vol into the market.

CS: - It is important, in our view, that the Fed continue to sell volatility – explicitly or implicitly – into the markets. This is at the heart of its quest to reduce term premiums and hence term interest rates. Buying mortgages results in a direct sale of volatility (prepayment risk) to the public. Extending the rate guidance to “mid 2015” represents an implicit sale of volatility – the Fed is giving up the option to hike (arguments about the Fed’s ability to renege notwithstanding).

Source: CS

Of course this is quite similar to the ECB's implicit put option on periphery debt (discussed here). As we've learned the hard way from the so-called "Greenspan's put", artificially suppressing volatility creates a "moral hazard" by forcing markets (including individuals and businesses) to misprice (and learn to ignore) risk.

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