Tag: QT

Tightening Only in Name

 

“We cannot control the way people interpret our ideas or thoughts, but we can control the words and tones we choose to convey them. Peace is built on understanding, and wars are built on misunderstandings. Never underestimate the power of a single word, and never recklessly throw around words. One wrong word, or misinterpreted word, can change the meaning of an entire sentence and start a war. And one right word, or one kind word, can grant you the heavens and open doors.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

 

In November 2010, esteemed investors and academics including Cliff Asness (AQR Capital), Jim Chanos  (Kynikos Associates), Seth Klarman (Baupost Group),  Paul Singer (Elliot Associates) and Michael J. Boskin, the T. M. Friedman Professor of Economics and senior fellow at Stanford University’s Hoover Institution, sent, the then Federal Reserve Chairman, Ben Bernanke an open letter warning him of the consequences of undertaking a second round of quantitative easing:  “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”

 

Monetary policy transmission mechanisms are amongst both the most confusing and most important concepts for financial market participants to come to grips with. Many of us misunderstood quantitative easing. We do not want to repeat the same mistake and misinterpret quantitative tightening.

 

For starters, quantitative tightening in not what is “rattling markets”.

 

One of the best explanations we could find on why quantitative tightening is not tightening in the normal sense comes from The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession written by Mr Richard Koo, Chief Economist at Nomura Research Institute. We quote (emphasis added):

 

“Under quantitative easing, the Bank of Japan supplied liquidity to the market. It did so by purchasing government bonds held by commercial banks, and crediting money to their current accounts. This process was repeated until the aggregate value of banks’ current accounts had risen to more than ‌¥30 trillion. To terminate the policy, this process had to be reversed. In theory, this would involve the bank selling government bonds to commercial banks to absorb the excess funds in their current accounts.

 

Selling government bonds should cause their price to fall, driving up interest rates. In practice, however, abandoning quantitative easing was not a “tightening” of monetary policy in the ordinary sense. In a standard tightening phase, the Bank of Japan responds to an overheated economy by selling bonds to commercial banks to mop up market liquidity and reduce the volume of money circulating. Commercial banks, on the other hand, normally try to maximise income on available funds by reducing liquidity on hand to the statutory minimum or thereabouts, and lend or invest the rest of their funds. Under these circumstances, commercial banks would not have the surplus funds needed to buy bonds from the Bank of Japan – their only option would be to sell other assets. In some cases, they might even consider calling in loans. So when the Bank of Japan starts selling bonds to commercial banks, banks are prompted to sell other financial instruments, driving down the price of financial assets in general (and thereby pushing up interest rates). This chain reaction of selling has a restrictive impact, and serves to cool economic activity.

 

But in terminating quantitative easing, the ¥25 trillion in surplus funds that the Bank of Japan sought to mop up was already sitting in commercial banks’ current accounts with the central bank, which pays no interest. Facing an absence of private-sector borrowers, the commercial banks could do nothing else with these funds. So when the Bank of Japan asked the banks to buy ¥25 trillion of government bonds, they paid for the purchases with money already on deposit with the Bank of Japan.

 

Because the banks did not need to raise funds elsewhere, the operation had none of the negative impact of a normal tightening operation, and interest rates did not rise significantly. Quantitative easing – the great non-event of the fifteen-year recession – vanished without a trace.”

 

 

For good measure, we also quote from Dr. Manmohan Singh’s article from FT Alphaville in April 2017, where he argues that the unwinding of the Fed’s balance sheet “may not be tantamount to tightening”:

 

“Deposits have taken too much balance-sheet space of the banking sector with excess reserves of the banks at the Fed are presently over $2tn. This inhibits financial intermediation and in turn, monetary policy transmission. As an analogy, oil is only needed for lubricating a car’s engine; similarly, excess reserves, are needed only to smoothen out the need for reserves in the financial system. They were close to zero before the Lehman crisis. Now instead of an “oil change” we are carrying the oil in the car trunk, in our homes, everywhere.

 

Markets currently can digest duration of good collateral. As seen in the past year, policy rate hikes may not percolate to the long end of the yield curve and vice versa, because the investor base is very different for the short and long end.

 

For example, from the time of the Fed’s 25 basis-point rate hike on Dec 16, 2105 until the eve of U.S. elections on November 8, 2016, the yield on the 10-year US Treasury note actually declined, to 1. 8 per cent from 2.3 per cent, as markets digested duration despite sizeable sales of Treasuries by many emerging markets throughout 2016.

 

So the unwinding of a central bank’s balance sheet may not result in tightening. Collateral that will be released (from the asset side of the Fed balance sheet) to the market, with reuse, is a far better lubricant for the financial system than the reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). Although the Dodd Frank Act and Basel III make it more expensive for collateral to be reused, the increase in the balance sheet space of the banking system (due to the central bank unwind) may more than neutralize the regulatory cost. Thus, a leaner central bank balance sheet, if it doesn’t result in a tightening effect, could justify a much higher policy rate in this cycle than currently being anticipated.”

 

Investment Perspective

 

If quantitative tightening is not tightening in the normal sense, this begs the question of what has gotten into global stock markets this year.  The simple answer is: we do not know for sure. It could be any one of a number of reasons or a combination of them. Some of the commonly cited explanations we have come across for the recent selloff include the escalating trade dispute between the US and China, the Chinese yuan breaking 6.9 to the US dollar, contagion from the selloff in emerging markets, fallout from the bond market route and, our favourite, that “TINA” (there is no alternative) no longer applies to stocks as the short end of the yield curve is now viable investment opportunity.

 

We think it may simply be a case of temporary exhaustion after accelerated pension contributions and cash repatriation by US corporations bid up US asset prices. With the deadline for accelerated pension contributions having passed and the rate of cash repatriation by US corporations slowing, the presence of ‘price insensitive’ buyers is likely to have diminished.

 

Regardless of the drivers behind the recent selloff, we think there still are compelling reasons to remain long US stocks. To expand on our reasoning, we return to Mr Koo’s book and present his yin-yang cycle of bubbles and balance sheet recessions:

 

Yin yang.png

 

We think, with the capital spending incentives in the Trump tax cuts, low employment and strong consumer spending, the US economy is in stage six of Mr Koo’s framework. US corporations are finally showing signs of increasing capital investment and there is a growing chance that the borrowing needs of the US Treasury are going to start crowding out the private sector. This could exasperate the situation for the US private sector, which is already under pressure to invest in increasing productivity to counteract tightness in the labour market and the pressure on margins from rising wages.

 

We think that under present conditions, the US economy can quickly accelerate from stage six to stage nine – the US fiscal deficit is expected to accelerate in 2019, even excluding any potential boost in spending from a revival in President Trump’s infrastructure spending bill.

 

We remain long US equities and are increasingly looking for opportunities to allocate capital to the industrial sector. We also think the time to increase allocation to non-US equities is upon us – for now we defer that discussion to another update.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

 

 

 

 

 

Quantitative Tightening May Not be as Scary as You Think

“You can be sure of succeeding in your attacks if you only attack places which are undefended. You can ensure the safety of your defense if you only hold positions that cannot be attacked.” – Sun Tzu, The Art of War

“I have absolutely no doubt that when the time comes to reduce the size of the balance sheet we’ll find that a whole lot easier than we did when expanding it” Sir Mervyn King, February 2012

 

In September, 2017 the Fed announced that it would start paring back its multitrillion-dollar balance sheet. The reduction will start modestly with USD 6 billion in Treasury bonds and USD 4 billion in mortgage backed securities a month. By the end of 2018 the pace of reduction is expected to reach USD 50 billion a month.

Ever since the Fed indicated its intention to gradually begin selling some of its bonds portfolio, opinions on the possible consequences of the balance sheet reduction have been divided. The equity bears argue that quantitative tightening will lead to a severe tightening of monetary conditions causing a recession and a stock market crash. The bond bears on the other hand argue that the added supply of Treasury bonds, at a time when foreign central banks are retreating from the Treasury market, will overwhelm the market, causing bond prices to fall sharply. While there are others that curiously argue that just as quantitative easing was expected to be inflationary but ended up being deflationary, quantitative tightening, which is expected to be deflationary, will cause inflation to spike.

We wonder, however, if quantitative tightening will turn out to be a non-event?

Prior to the global financial crisis, the Fed through the Federal Open Market Committee (FOMC) used open market operations – the buying and selling of government securities – as its primary tool to regulate money supply in the economy. The open market desk at the Federal Reserve Bank of New York would buy securities to increase the level of reserves held by banks – increasing money supply – or sell securities to remove reserves – to reduce money supply. There were also no interest payments on excess reserves.

As banks, in the ordinary course of business, try to maximise income on the given level of available funds, the opportunity cost for holding excess reserves prior to the crisis was high. Instead of holding excess reserves, banks, by lending or investing their assets, attempted to maximise earnings by reducing liquidity to as close to the statutory minimum as possible. According to the Federal Reserve Bank of Cleveland, from 1959 to just prior to the financial crisis, the level of reserves in the banking system remained stable, growing at an annual average of 3.0 percent over the period – in line with the growth rate of deposits. Excess reserves’ share of total reserves, outside periods of extreme uncertainty or economic stress, was also stable, rarely exceeding 5.0 percent.

Under the circumstances prior to the financial crisis, banks did not hold surplus funds needed to buy bonds from the Fed. Their only option to generate funds was to sell other assets or call in loans. So when the Fed sold bonds to the banks, the banks sold other financial instruments, driving down the price of financial assets and pushing up interest rates. This selling tightened monetary conditions and served to cool economic activity.

In response to the global financial crisis, the Fed injected large amounts of reserves into the banking system and introduced new mechanisms that encouraged banks to increase their level of excess reserves. Since December 2008, the Fed pays interest on all banking reserves, including excess reserves, thereby increasing the marginal benefit of holding excess reserves as compared to before the crisis. At the same time, the heightened levels of risk in other securities and lending combined with an increasing regulatory burden reduced the marginal benefit of the alternatives to parking money at the Fed. The decision to pay interest on banks’ excess reserves also ensured that the mass injection of liquidity did not result in short-term rates falling below zero, thereby putting a floor on short-term rates.

Interest on Excess Reserves vs. Fed Funds Rate and 90 Day T-Bill Discount RateIOERSource: Bloomberg

A number of liquidity-easing programs to alleviate some of the stress in the financial system were also implemented by the Fed. The largest of the liquidity programs implemented, quantitative easing, involved the Fed purchasing Treasury securities, federal agency debt and mortgage-backed securities primarily from non-banks. These purchased assets were then converted into deposit liabilities at the banks. As a consequence of these asset purchases and their conversion to deposit liabilities, excess reserve balances at the Fed expanded greatly and as of 25 October, 2017 stood at USD 2.14 trillion.

Excess Reserves of US Depository Institutions (USD million)Excess ReservesSource: Federal Reserve Bank of St. Louis

To undertake quantitative tightening, the quantitative easing process will have to be reversed. This will involve the Fed selling the securities it purchased to banks in order to absorb the excess funds in their current accounts. As bond bears postulate, this selling of government bonds should, in theory, cause their price to fall, driving up interest rates. In practice, however, if the Fed does not shrink its balance sheet by more than the level of excess reserves in the banking system, quantitative tightening will not be a “tightening” of monetary policy. In a tightening phase, the Fed would be selling bonds to banks to soak up market liquidity and reduce the volume of money circulating. However, for any level of quantitative tightening up to the USD 2.14 trillion in excess reserves, the funds are already available in the banks’ accounts with the Fed. As banks will not need to raise funds elsewhere, the operation, in our opinion, is unlikely to have the negative impact of a standard tightening operation, and interest rates should not rise as a direct consequence of quantitative tightening.

The next question that comes to mind then is why undertake quantitative tightening now? The answer to that, we think, lies in the very reason many feared quantitative easing would cause inflation to spike.  Quantitative easing did not result in high levels of inflation as there was little demand for debt financing, other than for corporate share buybacks and mergers & acquisitions. As long as there is no demand from would be borrowers, no amount of quantitative easing will result in inflation. However, as we argued in The Case for a Pickup in US Inflation, the capital expenditure cycle may be picking up and that may spur an expansion in credit issuance.

Of the aggregate reserves of depository institutions held with the Fed, only around USD 127 billion, as of 25 October, 2017, are required to satisfy reserve balance requirements.  Accordingly, the USD 2.14 trillion in additional reserves can potentially support a level of money supply much larger than that exists today. By absorbing these excess reserves, the Fed will reduce the possibility of a drastic expansion in bank lending and money supply that could destabilise the economy.

 

Investment Perspective

Much like Pavlov’s dog, we, as market participants, have been conditioned by the pairing of a neurologically potent stimulus, such as directional market action, with a neutral stimulus, such as the Fed’s policy decisions, to elicit a response. The nature of our response is ultimately conditioned by our most formative experiences within markets. The direction of market action that was most recurrent subsequent to the application of a particular Fed policy during this time is most likely to become our default expectation whenever the policy is implemented again.

The market regime experienced by the vast majority of market participants today is the one where banks’ excess reserve levels were modest and the Fed selling bonds resulted in interest rates rising. Quantitative tightening involves selling of bonds by the Fed, ipso facto, financial conditions will tighten and interest rates will rise so sell bonds. We consider this to be a systematic error caused by conditioning under an altogether different market regime.

Quantitative easing was a compelling reason to buy long-dated government bonds. Quantitative tightening, on the other hand, is not a sound reason to be selling or shorting long-dated Treasury securities.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.