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Posts Tagged ‘Fed’

Putting the QE toothpaste back in the tube

Posted by Danny on November 19, 2018

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):

Fed_assets

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#):

excess

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):

banks_treas

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:

tlt

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.

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Quantitative squeezing – what you need to know

Posted by Danny on October 16, 2017

Stock markets keep inching higher and people probably start thinking that nothing can bring them down. Real volatility has also dropped to new all time lows. That’s strange because there is unusual uncertainty on the horizon already. The US Fed has announced that it will start unwinding its decade old QE programs and that’s something that has never been tried before. They present it as a non-event that will be like watching paint dry and maybe enough investors are believing them… Anyway, I will give my observations on how this “quantitative squeezing” is likely to unfold, but first a look at the current S&P 500 chart:

^SP500 (Daily) 1_26_2016 - 10_13_2017

This market keeps advancing within the narrow channel (red) it has been occupying for most of the year (with the exception of a brief breakout attempt in February). The S&P is at new record highs and bumping into the ceiling of this trend channel. This advance has lifted the MoM index into the +8 euphoric zone, which usually marks peaks. The Earl (blue line) has turned down already with a bearish divergence in place. The Earl2 (orange line) is still climbing and has reached its highest level since early January. When the Earl2 turns down we will probably have an important peak in place. This not the kind of setup to do new buying. The risk/reward is too poor. Our LT wave for October shows a peak on the 19th, so that’s something I would also keep an eye on this week.

Now, let’s have a look at quantitative easing (QE) and what will happen when it reverses into quantitative squeezing (QS). Will it be a non-event, as they want us to believe? If so, then why are they starting it with a paltry $10B in the first month(s)? The reality is they are shaking in their boots. This is not mere tightening like when rates are being raised. This is about squeezing a few trillion $ out of an economy over the course of a few years. If putting those $trillions in supposedly saved the economy then it makes no sense to think that taking them back out will have no effects. That’s like putting the engine off in a helicopter and tell the passengers that it will keep flying all the same.

There are a few charts that you will want to watch as this QS gets underway. All can be found on the Fed’s own websites. The first one is the so-called balance sheet of the Fed (https://fred.stlouisfed.org/series/WALCL):

CB_assets

It is easy to see how their holdings have jumped up with the asset purchases done for the QE programs since 2008. I have extrapolated the original growth rate of their total assets prior to the QE experiment (orange line) and that shows us the Fed has to unload about $3.3T worth of paper if it wants to get back to “normal”. They say they will do that gradually by not rolling over some of the bonds at maturity, thereby suggesting they will not do any direct selling. But that’s just smoke and mirrors. When the Fed doesn’t roll over some Treasuries when they are being refinanced then new buyers need to be found for that portion the Fed is unwinding. When bonds mature it is not like a lottery ticket that expires worthless. The principal needs to be payed back (+ interests) and that money will have to be found elsewhere if the Fed doesn’t roll over its assets. So, where will those new buyers come from? Well, not everyone has $ billions lying around, but the first candidate buyers can be seen here (https://fred.stlouisfed.org/series/EXCSRESNS#):

Excess_Res

Most of the QE money went into excess reserves at commercial banks. They still have a little over $2 trillion in excess reserves and that money will inevitably become a buyer of the assets the Fed is unwinding because primary dealers are required to pick up the unsold portion on treasury auctions. You will want to watch this chart during QS to see how quickly their excess reserves dwindle. Once that money starts running out it will become problematic for the Fed to continue unwinding because then buyers with deep pockets will have to be found elsewhere. Problems may start well before that point because commercial banks could balk at picking up more treasuries unless a more attractive long term interest rate is offered. Historically commercial banks have held a portion of their assets in government paper and this is the third chart you will want to watch as QS unfolds (https://fred.stlouisfed.org/series/USGSEC#0):

bank_own

Banks have typically held about 10% of their total assets in government paper. That was also the case in 2008. Since the start of QE banks have been net buyers of $1.2T worth of treasury and agency securities, doubling their stake and now more than 15% of total assets. We can easily see where all the QE money has gone: two thirds went into excess reserves and the rest was used to buy government paper. Are those banks now going to be eager to use all their excess reserves to buy another $2T worth of bonds for their own accounts? They would be well on their way to become a bond ETF rather than a bank if they do so. Those bankers will try to unload some bonds on the public and this chart will tell us how successful they are in doing so. If their treasury holdings go up just as quickly as the Fed unwinds theirs (chart 1) then we will know that the broader public has little or no appetite for this paper and then QS will be in trouble.

Of course they could use a few tricks to boost public appetite for treasuries. E.g. Fed could announce that long term inflation target has been lowered to 1%, saying that low inflation has become a permanent feature of the economy. In a 1% inflation world a long term bond yielding 3% would look OK, especially compared to richly priced stocks. And a stock market crash could also beef up the demand for bonds. But for how long? NYSE tells us that stock investors currently have some $291 billion cash in their accounts and $550 billion in margin debt (http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8). Good luck in trying to peddle them a portion of the assets the Fed will be unwinding.

Will foreign investors pick up the tab? Not likely. Official foreign holdings of US treasuries is around $6T. Latest data suggest they are trying to reduce their holdings: http://ticdata.treasury.gov/Publish/mfh.txt.

Investors understood that QE was like having a persistently large buyer in the bond markets and that money spread into other markets. They will soon realize that QS is like having a persistently large seller in the market and that transition will feel like a kind of squeeze because money is taken out. My guess is that QS will seem to go smooth in the beginning, especially when other central banks like ECB are still in ongoing QE programs. But as excess reserves dwindle at commercial banks it could turn ugly without any warning. So, I think they will be forced to stop QS well before their balance sheet gets anywhere near the old “normal”. Trying to unwind all the way to “normal” would cause a financial crisis that is worse than the one they happily believe to have solved with QE. Once that is understood they will settle for freezing their balance sheet at a high level for an indeterminate period of time. And they will still want us to believe that their actions have saved the economy. But in reality the economy will have saved their actions.

Posted in Market Commentary | Tagged: , , , | 6 Comments »

 
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