Last year I wrote an article on what to look for when the Fed unwinds its QE program: Quantitative squeezing – what you need to know.
Since the start of QT (quantitative tightening) the stock market is more or less flat and long term bonds are down about 10% yoy.
Let’s have a look at how the unwind is progressing and detect possible implications for investors.
The Fed’s balance sheet remains the main chart to watch (https://fred.stlouisfed.org/series/WALCL):
From $4.46T a year ago the balance sheet is down to $4.14T, or an unwind of $320 billion. At this rate it would take about 10 years to get to a balance sheet that is back in line with the levels prior to 2009. As I pointed out last year, that’s not going to happen. Trying to put all the QE toothpaste back into the tube would create an economic crisis that is worse than the one they claim to have “solved” with their QE program.
I pointed to excess reserves held by commercial banks as the prime candidate to pay for the unwind. Here is the current situation (https://fred.stlouisfed.org/series/EXCSRESNS#):
From $2.2T excess reserves a year ago the banks are down to $1.75T. That’s a reduction of $450 billion. It does look like those excess reserves are indeed picking up the QT tab. But the interesting thing to note is that a $320 billion QE unwind came with a $450 billion reduction in excess reserves. A reduction at this rate could continue for another 3 years, bringing the Fed balance sheet to around $3T, but that would still be three times higher than it was before the crisis. Essentially, the excess reserves of banks are back down to late 2011 levels already, with the Fed’s balance sheet still $1.3T above its late 2011 levels. This is a strong indication that only a partial unwind of QE will be possible.
I also keep an eye on commercial banks’ holdings of government paper (https://fred.stlouisfed.org/series/USGSEC#0):
There is only a small rise from $2.49T a year ago to $2.56T now, an increase of $70 billion. This means banks are not showing much appetite for the debt paper that the Fed is unwinding, which is what I expected.
How about foreign buyers? Official foreign holdings of US treasuries were around $6.3T a year ago and are down to $6.2T now. Largest holders China and Japan have reduced their holdings and Russia has sold almost all its US treasuries. Predictably, those foreign buyers are also refusing to become QT bagholders: http://ticdata.treasury.gov/Publish/mfh.txt.
This weak demand by major participants is why longer term treasury bond prices are down 10% over the year:
How about cash on the sidelines held by stock investors? The data are now here: http://www.finra.org/investors/margin-statistics
Stock investors have about $340 billion in cash and $650 billion in margin debt. Not much change. With those numbers we can’t expect stock owners to play much of a role in a $3T QE unwind. If anything they may panic alongside bond holders at some point, because margin interest rates go up together with rising Fed funds rates.
The question becomes: how much more QT can be done before it causes global bond market stress and starts choking the economy? We may be reaching that point already. If Europe and Japan start their own QT it could become even more interesting.
My guess is that QT in the US will be stopped (paused) as soon as excess reserves at commercial banks approach zero. It may be stopped even before that point. Stock and bond markets could show a very positive response to any such announcement. That’s going to be a wild card for investors in the year(s) to come. At some point it will be concluded that it is more desirable to freeze central bank’s balance sheets at their elevated post-2010 levels. Europe, Japan and China may never start their own QT (or only do a small symbolic reduction) because their economy remains too weak to take it.
A possible side-effect of doing too much QT would be an unexpectedly strong US dollar because it makes dollars more scarce.