Distinguishing the Fed's securities purchases from monetary expansion

There has been a bit of confusion about what today's FOMC announcement means with respect to Quantitative Easing. The statement says that " the Committee decided to conclude its asset purchase program this month". It's important to point out that while this is the end of the Fed's bond purchases (for now), the US monetary expansion has ended this past summer. The outcome is visible in the the banking system's excess reserves, which flattened out around July.

That in turn resulted in the US monetary base leveling off at just below $4.1 trillion, as the so-called "money printing" effectively ended in July.

This begs the question: How is it that the excess reserves and the monetary base stopped growing this summer while the securities purchases and the balance sheet expansion continued through October? The answer has to do with some other balance sheet items that offset ("absorbed") reserve creation. The key item to consider here is the Fed's reverse repo position, which became more impactful as the securities purchases ebbed.

While the Fed's securities program is just ending now, the US monetary expansion was finished months ago. Therefore, other than its psychological effect, today's announcement should have a limited impact on the economy.

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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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US benefiting from reduced policy uncertainty

It is becoming increasingly clear that the Fed's taper, the slowdown in the central bank's balance sheet growth (chart below), is unlikely to damage credit expansion in the US.

Fed's balance sheet (YoY)

In fact - and many economists find this counterintuitive - the certainty of taper trajectory (which is effectively on autopilot) seems to be stimulating loan growth. In the post-financial-crisis world, periods of shifting government policy (both fiscal and monetary) had been quite damaging for the economy. The reduction in nearterm uncertainty with respect to the US fiscal impasse (see story on federal budget and on debt ceiling) is likely to be helping the situation as well. Loan growth acceleration in recent weeks has been quite pronounced.

Total loans in the US banking system (YoY)

This stabilization stands in sharp contrast to what is taking place in the Eurozone (see post) and seems to be fairly broad based. Small US banks, where credit growth had slowed materially in the wake of the US government shutdown, are now showing improvements in non-cash asset growth, especially corporate loans.

To be sure, much of this sudden recovery has less to do with banks suddenly easing credit and more to do with improving demand, especially in the corporate sector. That's because banks typically don't turn on a dime - they loosen credit policies far more gradually as a whole. This trend is therefore more indicative of bank credit facilities being drawn, particularly for working capital. Having said that, the Fed's senior credit officer survey does indicate lending standards easing in Q4 of 2013.

The data on loan growth is supported by high frequency survey results. Last week's ISI Bank Loan Survey index rose to the highest level since 2008. It is increasingly likely that the US economy will not only be able to withstand the gradual conclusion of QE3 but may actually benefit from the reduced monetary policy uncertainty.

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The bitter medicine of quantitative easing

Barry Ritholtz wrote an opinion piece on Bloomberg today arguing that it's hard to criticize the Fed's QE programs simply because we don't know what would have happened without them. Since this is not a "controlled" experiment in which we can compare a patient taking experimental medication with the one taking a placebo, there is no way to tell if the therapy had worked. All we know is that the patient has undergone a slow recovery and according to the "doctor" may have been worse off without the "treatment".

"If you are testing a new medication to reduce tumors, you want to see what happened to the group that didn't get the test therapy. Maybe this control group experienced rapid tumor growth. Hence, a result where there is no increase in tumor mass in the group receiving the therapy would be considered a very positive outcome."

This argument was used a number of times in recent years, including for example with the American Recovery and Reinvestment Act of 2009 - the $840 billion "stimulus" bill. There are all sorts of estimates on how many jobs the bill saved/created and how many GDP points were added. Was it effective relative to other job creation programs? We of course will never know because we can't peer into an "alternative universe" where the stimulus bill had not passed.

But maybe we are asking the wrong question. Let's for a moment stay with the medication analogy that Mr. Ritholtz introduced. Experimental medication is usually applied in dire cases when the patient's health is deteriorating and traditional therapies had not worked. The use of the first round of quantitative easing, QE1, was just such a case. It was necessary to stabilize the banking system that was frozen - an extreme problem that called for radical measures. But what about QE3? Mr. Ritholtz argues that with other parts of the federal government dysfunctional, the Fed was simply the only game in town to get the economy moving.

However was the US economy in such a disastrous shape in the summer of 2012 that it called for another extreme intervention? Clearly growth was uneven and the labor markets remained wobbly. Nevertheless a recovery was taking place. A patient who is getting better, albeit slowly, is generally not given an ever larger dose of experimental medication in hopes of miraculously accelerating the recovery.

Rather than Mr. Ritholtz's tumor analogy, let's think about QE as delivering excessive doses of experimental pain killers. Yes the patient may feel better at first, but as we all know, prolonged use could create some nasty side effects. The key side effect of course is addiction - which over a long period of time requires one to administer ever larger doses in order to obtain the same effect. And now you are not just fighting the disorder but also the withdrawal symptoms. That is precisely what is taking place these days (see post). Furthermore, the uncertainty surrounding the QE "withdrawal symptoms" is what had put some of the economic activity on hold, activity that is only now beginning to return (see post).

What's particularly troubling about QE is that even after the "injections" are taken away, the nation's banking system is saddled with the "long-term side effect". The US monetary base is now near $4 trillion, with some $2.5 trillion of it sitting on banks' balance sheets in the form of excess reserves - a situation with no precedent. Removing it would require the Fed to sell its securities holdings - something the central bank is not planning to do. This bloated monetary base is going to be with us for a while even as the Fed's securities purchases end - an "experimental drug" whose long-term effects remain unknown.

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The big steepener unwind

Since the Fed announced the reduction in securities purchases ("small taper"), the treasury curve has undergone some strange adjustments. Here is what the impact has been since the close on December 17th. Why would the 5-year note sell off the most while the long bond rallied?

The answer has to do with how the market was positioning prior to this event. Many traders had two expectations:

1. Taper is coming next year and the impact should raise long-term rates
2. The Fed will keep short term rates near zero for a long time

The trade that takes advantage of this view is the so-called "steepener" trade - long short-term treasuries and short long-term treasuries. And that's how the market was positioned going into the announcement. But a combination of the "early" taper, stronger than expected economic data (below), and a less than stellar 5-year note auction made some question the #2 assumption above.

Source: Investing.com

After what we've seen over the past five years it is difficult to imagine this scenario, but what if the US economy unexpectedly accelerates? The Fed will be forced to begin pushing short-term rates up faster than originally expected. The market started to price in a higher probability of just such an event. As an illustration, take a look at the June-2015 fed funds futures contract. The steepener trade had pushed the first rate hike expectations further out in time (higher futures price = lower expected fed funds rate). But the announcement, combined with improved economic data, forced a selloff in the contract - with the market now expecting the first hike by the middle of 2015.

This earlier-rate-hike scenario impacts shorter-term treasuries more than it does longer-dated notes/bonds. The adjustment in expectations forced an unwind of the steepener trade, creating the "flattening" move in the yield curve we see in the first chart above. Anecdotal evidence suggests that this unwind ended up being quite painful for a number of market participants who had piled into the trade.

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If QE is "heroin", what is "methadone" and how do we avoid "side effects"?

The Federal Reserve remains concerned about exiting the massive bond buying program that has been in place for over a year now. The program has become a bit of a trap (see post), creating a dependence on unsustainable levels of stimulus. The concern is that in an environment where inflation is at historically low levels, cutting back on monetary stimulus could put significant downward pressure on prices, creating deflationary pressures and forcing the Fed to resume or even increase the program (similar to Japan). Using the addiction analogy (see this video for example), this is the equivalent of a relapse risk for those suffering from substance abuse. It turns QE from an extraordinary crisis fighting mechanism meant to be used only under extreme situations into an ongoing monetary policy tool. The Fed desperately wants to return to the days of simply adjusting short-term rates to drive policy.

So how does one minimize the impact of taper to reduce the probability of returning to "unconventional" programs? One approach is something that opiate addiction clinicians have been using for some 30 years. An effective treatment for heroin addiction is the use another, less dangerous opiate called methadone. It reduces withdrawal symptoms without creating intoxicating or sedating results, helping many addicts quit. So if heroin is analogous to the Fed's QE program for the economy, what is the equivalent of methadone?

Many are arguing that lowering the Interest on Excess Reserves rate (IOER) could potentially counteract some of the QE withdrawal symptoms. IOER is currently at 25 basis points, and while that was considered to be extraordinarily low back in 2008 when it was introduced, in the days of record low short-term rates many view it as being too high. That's because banks are quite comfortable paying near-zero on deposits (including deposits from the Federal Home Loan Banks) and receiving 25bp on reserves - a riskless way to generate revenue (see post). That spread according to some is holding back credit expansion in the US. The chart below shows growth in non-cash assets of all banks operating in the US - an unsettling trend for many economists.

By making it less profitable to hold on to cash, some argue that lowering the rate on reserves should "dislodge" the barrier to a more vibrant credit expansion.

Reuters: - The [IOER] rate has been criticized, however, for encouraging banks to park cash idly with the central bank instead of using funds to lend to companies and consumers that many say is needed to stimulate the economy and reduce unemployment.

Yellen, who has been nominated to succeed Fed chair Ben Bernanke at the end of January, said on Thursday that cutting excess reserves is "something that the FOMC has discussed, and the board has considered, on past occasions, and it is something we could consider going forward."

When cutting this rate simultaneously with the first series of cuts in securities purchases, the Fed could attempt to blunt the "withdrawal symptoms". This may avoid the "cold turkey" taper, which many view as dangerous given the disinflationary trends in the United States (see Twitter chart) and elsewhere in the developed world. So why hasn't the Fed already taken this step? As with any medication, this form of "methadone treatment" may have some side effects.

Europe found out the hard way that setting the rate on reserves to zero can severely damage the money markets industry - which is basically what happened in the euro area after Mario Draghi's rate announcement in July of 2012 (see post). While we've received emails arguing that money market funds are irrelevant, one has to keep in mind that in the US and offshore the industry holds $2.7 trillion of dollar deposits. Nobody wants havoc in that sector, particularly as taper takes hold.

That's why the Fed has been working on a way to avoid this potentially dangerous complication. It is called the Overnight Reverse Repo Facility (discussed here). This tool gives the Fed some control over the short-term rates outside the banking system to make sure money market rates do not dive below zero. Money market funds would be allowed to effectively deposit cash directly at the Fed (technically they would be lending to the Fed) and earn rates that are above zero. The program would set a floor on the overnight rates and in the long run the facility could be used in conjunction with (or even instead of) the fed funds rate to drive monetary policy.

Reuters: - Market speculation that the Fed may be nearer to acting on a cut also increased on Thursday after influential firm Medley Global Advisors said in a report that the Fed may cut the excess reserve rate, noting that it has more flexibility to do so now that it has been testing its reverse repurchase agreement program.

In reverse repos, the Fed temporarily drains cash from the financial system by borrowing funds overnight from banks, large money market mutual funds and others, and offering them Treasury securities as collateral. This helps the Fed control short-term rates as the supply of collateral can stop market disruptions from rates falling to zero or into negative territory as cash floods into short-term markets.

The Fed has been testing this program since September.

"The logic for cutting the IOER now, would be to better align the IOER with other short-term rates and hopefully encourage greater market-based lending," said Kenneth Silliman, head of short-term rates trading at TD Securities in New York.

"With the creation of reserve draining facilities, like the Overnight Reverse Repo Facility, the Fed now has the ability to better align rates without destabilizing money markets given that the Fed can essentially put a 'floor' on short-term rates by injecting collateral/draining reserves into the market. This would have a stabilizing effect," he said.

We could therefore see the Fed execute all three policy changes at the same time:
1. Taper (weaning the economy and the markets off QE "heroin")
2. Reduction in the IOER rate to encourage lending (methadone treatment for reducing withdrawal symptoms)
3. Introduction of the Overnight Reverse Repo Facility to keep the overnight rates from dropping below zero and destabilizing money markets (managing medication side effects).

Of course it is not entirely clear if lowering the IOER rate will encourage significantly more lending. However such action will certainly send lenders to seek out other sources of revenue in order to replace the easy money generated by the current spread between IOER and deposit rates.

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South Africa struggling as Commodities Super Cycle wanes

The end of the global "commodities supercycle" (see post) has been devastating for a number of nations with significant natural resource export sectors. Over the past decade, the rise in commodity demand and prices has often masked structural issues in many of these nations and delayed much-needed reforms and industry diversification. When the good times ended, a number of countries were caught unprepared. Some argue that the impact is not limited to emerging markets and includes to some extent nations such as Canada (see post) and Australia (see post).

South Africa is certainly part of that club. Growth is stagnating, with structural problems creating serious headwinds. Here is a quite from a Sober Look reader, an investment professional based in South Africa:

Despite the relative stability , there remains enormous structural headwinds to growth. Limited power supply (state-owned power company is struggling to meet demand , with existing fleet on average 30 to 40 years old) and inflexible labour markers. GDP growth this year could be 2% or less and with commodity prices falling , current account deficit will average 5% - 6% of GDP ..

However, the biggest challenge is unemployment ( officially 25% but above 30% including discouraged job-seekers ) .. This creates enormous socioeconomic and populist pressures which the ruling ANC is struggling to contain .. In my view it was a mistake for the ratings agencies to give SA an investment grade rating in the first place while the unemployment rate was/is so high. ..

With commodity prices declining, the nation's export sector has been struggling. At the same time foreign investment growth remains quite weak. This resulted in a sharp decline in South Africa's current account (reported yesterday.) The number came in at -6.3% of the GDP, far worse than expected.

Source: Tradingeconomics.com

As the nation mourns the passing of Nelson Mandela, the realization is sinking in that South Africa is facing growing economic and political uncertainty. And ironically, the stronger economic data out of the US creates further headwinds by lowering demand for rand and South African government bonds.

Bloomberg: - Traders are turning more bearish on the rand after the currency’s slide this week to a more than 4 1/2-year low, sparked by speculation the Federal Reserve will start curbing stimulus sooner than anticipated. Foreign investors, who own about 37 percent of South African government bonds, dumped the debt for 12 straight days through yesterday, the longest run since Bloomberg began compiling data from the Johannesburg Stock Exchange in 1996.

“It has been a torrid November, and we’ve started badly in December too,” Mohammed Nalla, head of strategic research at Nedbank Group Ltd., said by phone from Johannesburg yesterday. “The guys are positioning for the possibility of a taper in December. What’s worrying is that the rand is building up a bit of momentum, and if does, it can go quite far.”

The chart below shows long-term trend in the rand (USD/ZAR) exchange rate against the dollar. Note that the chart shows dollar appreciating and the rand weakening.

Source: Investing.com

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Why Fed's taper is essential to stabilize agency MBS liquidity

While we've discussed some of the economic implications of the Fed's current policy, let's now take a quick look at the impact of QE on the overall mortgage bond market.

Here is a simple fact: the amount of mortgage-related securities in the US has been declining since 2008 - after reaching just over $9 trillion at the peak.

Source: SIFMA

The reason is simple. With a large portion of all mortgages funded via the bond markets, the ongoing decline in total mortgages outstanding results in smaller MBS balances. Of course as the population grows and more homes are built (albeit very slowly) this trend should reverse.

And now with these market dynamics as the backdrop, put the Fed into the mix. At it's current pace the Fed is taking about half a trillion of MBS securities out of the market. In fact the Fed is now removing more than 100% of the paper that is being issued. The supply of agency (Fannie and Freddie) MBS securities in the market is declining sharply as the Fed reduces the total "tradable float".  According to Credit Suisse, without the Fed's anticipated taper in Q1, the demand for agency paper could outstrip the supply by $340bn in 2014, creating a liquidity problem.

CS: - Liquidity in the MBS market could come under pressure in the coming months due to Fed’s settled purchases exceeding 100% of gross issuance of non-specified conventional 30-year pools. Tradable float in conventional 30-year MBS should decline between 6% and 30% during the year, increasing the risk of a potential liquidity disruption in the market under longer taper delay scenarios.

As a result some of the private participants, particularly banks, have been reducing their agency MBS holdings. The chart below shows the year-over-year changes in MBS holdings by commercial banks.

Here is what the conventional 30-year agency MBS float will look like under the taper vs. no-taper scenarios (chart below). Without the taper, the float in these bonds will decline by 30% from the October levels. These are dangerously low levels for what used to be one of the largest bond markets in the world.

Source: Credit Suisse

Taper therefore becomes essential in order for liquidity to stabilize and for more private market participants to begin returning to this market.

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5 years of QE and the distributional effects

As we approach the fifth anniversary of the start of the first quantitative easing program, some are asking the thorny question about the so-called "distributional effects" of these unprecedented programs. Who really benefited since the first QE was launched? There is a great deal of debate on the topic, but here are a couple of facts. Financial asset valuations, particularly in the corporate sector have seen sharp increases. For example the S&P500 index total return (including dividends) has delivered 144% over the 5-year period. Those who had the resources to stay with stock investments were rewarded handsomely.

Source: Ycharts

But what about those who didn't have such an opportunity? For example savers, particularly retirees who had to stay in cash? They were hurt severely by record low interest rates (negative real rates - see post). And those who had neither the savings nor significant stock investments, relied on house price appreciation or growth in wages. The housing recovery has certainly been helpful (for those who kept their homes), but according to the S&P Case-Shiller Home Price Index, US housing is up less than 5% over the past five years. Not much of a "wealth effect" for those without stock portfolios. And when it comes to wage growth, the situation isn't much better. The chart below shows hourly earnings growth of private sector employees.

It therefore shouldn't be a surprise that the three rounds of quantitative easing over the past five years rewarded those who had the wherewithal to hold substantial equity investments. Everyone else on the other hand - which is the majority - was not as fortunate.

Perhaps the best illustration of these distributional effects is in the chart below. It shows the relative performance of luxury goods shares with wealthier clients vs. retail outfits that target the middle class. The benefits of QE are clearly not felt equally by the two groups.

Source: JPMorgan

So as we prepare for the Janet Yellen's ultra-dovish Fed (see story), it's worth thinking about the past five years and the cost of growing distributional effects in the United States. For now there is plenty more cheap money to help those with large stock portfolios.

JPMorgan: - There are debates about whether a 0% cost of money helps anything except financial asset prices ... All we know is that the Fed has a story to tell (“cheap money is good”) and they are sticking to it.

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Low inflation creating a QE trap

Weak inflation readings in the US continue provide the Fed with the rationale to maintain securities purchases in what amounts to a "QE trap". With the PCE inflation measure once again below one percent, the FOMC doves fear that "taper" could bring about deflationary pressures. The risk of course is that inflation measures remain benign and what was meant to be a short-term policy measure extends beyond anyone's expectations.

Scotiabank: - The Fed’s preferred measure of inflation — the price deflator for total personal consumer expenditures — came in at +0.9% y/y in September. We feel that markets are underestimating the importance of this observation to the Fed. That is tied with April for the softest inflation reading since October 2009 when the US economy was just beginning to emerge from recession.

The forward looking inflation measure derived from TIPS yield (breakeven), has now also turned lower after a recent upward movement.

Similarly, we've seen a slump in commodity prices (see discussion), which is another signal of weak inflation readings.

With inflation measures remaining this low, many argue (see story) that there is no rush to begin exiting the current monetary policy. The fact that the US monetary base is now 4.5 times greater than it was 5 years ago and capital markets are now fully addicted to ongoing stimulus does not seem add any urgency for these economists. The longer this goes on, the more difficult will be the exit, making it harder for the Fed to pull the trigger. Welcome to the QE trap.

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Comparison to an earlier period of accommodative monetary policy

Here is an observation. The last couple of years show some interesting similarities to the period ending in early 2005. The reason for such a comparison is that then, just as now the Fed began to gradually exit its highly accommodative policy.

Both periods show similar trends in the unemployment rate, although the absolute levels are quite different. That, at least in theory, is usually the rationale to consider exiting stimulus.

Similarly housing prices show an upward momentum during both periods. Obviously the speculative fervor of the pre-recession housing market is (supposedly) not present in the current environment.

The Fed's stimulus of course came in different forms for the two periods. In the pre-recession era, the Fed used the overnight rate to provide accommodation, which dipped down to 1% at the peak of the stimulus. In the current environment - with the overnight rates effectively at zero - the stimulus is in the form of longer-term rates which are adjusted via securities purchases. The chart below shows the stimulus (blue) and the start of the exit for both periods. The trends in the "risky" assets are quite similar during those periods.

What does this say about the current environment? The accommodative period that started with the burst of the tech bubble and ended in 2005 may have been overdone, igniting the housing bubble through artificially low rates (see post from 2009). The exit did not end well, as rising rates sent shock waves through the overleveraged housing market. The current stimulus cycle is of course quite different. Nevertheless the lesson here is that the longer the accommodation period the more dangerous the exit (as we already saw with the emerging markets rout).

Update: Here is an excellent comment on the topic from Joseph Longino of Sandler O'Neill -

The fact that the 16-day partial closure of the federal government has prolonged quantitative easing reveals how far the Fed has moved beyond crisis management to the quotidian calibration of the post-crisis economy. The core job description of a central bank in a capitalist economy, including the Fed, is not to fine-tune the economy or financial system but to help secure the broader stability that inspires in private participants the confidence necessary to make plans for tomorrow rather than to be fixated on today or, worse, yesterday.

Five years ago, in the depths of the crisis, the Fed and U.S. Treasury distinguished themselves among their international peers by masterfully intervening to avoid global collapse. However, yesterday is not today, and every time the Fed magnifies the putative importance of quantitative easing in the public consciousness by further delaying tapering, it administers a reverse placebo effect to the recovering patient, increasing anxiety that the crisis hasn’t passed at all but lies in wait for the unwary, and risking a systemic shock when measured tapering is no longer practicable or possible.

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Who benefits from the Fed's decision?

The FOMC's decision yesterday to continue buying securities at the same pace moved a number of markets. But who exactly benefited from these moves (h/t George H)?  Here are a few select markets.

Stock investors got a nice boost and precious metals investors enjoyed a strong spike. These folks should be quite happy. But then we also saw copper spike almost 4%. It's not difficult to predict how US manufacturers and building contractors feel about that.

Mortgage rates declined - a full 14 basis points. So that's the impact on the "real economy" of delaying "taper"? To make matters worse the decline in jumbo mortgage rates was higher than in conforming mortgages. Between the pop in investment portfolios and the drop in jumbo rates, those who are well off to begin with are more likely to benefit from this policy decision. Was that the intent?

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Digging a deeper hole

Looks like our assessment has been wrong. The current FOMC, who has chosen to stay the course on securities purchases, is even more dovish than many had predicted. The Fed is following a dangerous path. Nevertheless the markets love it.

We've seen the damage even a hint of exiting this program did to emerging markets. The deeper the US central bank gets into this hole, the more difficult the eventual exit will become.

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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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India, Brazil should thank Bernanke for their currency woes

India and Brazil are struggling to regain control of their currencies as both the rupee and the real touch new lows (all-time record for the rupee). It is remarkable how violent the corrections have been in just the past 3 months:

Green = rupees per dollar; Blue = real per dollar 

For those who don't watch these currencies on a daily basis, these sell-offs seem to happen in spurts - almost at random. But there is a pattern here, particularly in the past few months. Investors are dumping these currencies during periods of higher expectations of the Fed's slowing its securities purchase program. The evidence for the pattern is in the correlation between these exchange rates and the US treasury yields. Since Bernanke's first comments on slowing the securities program, currency weakness consistently corresponds to higher US yields resulting from sharper taper expectations (see post).

Brazil

India

The prospects of higher long-term interest rates resulting from the Fed's taper is forcing investors out of emerging markets - and these two nations are feeling the brunt of this "rotation". To be sure, we have no way of knowing if this would have still occurred if the Fed had not initiated QE3 a year ago. But the severity and the speed of these corrections would suggest that this is one of those unintended consequences of applying and then trying to exit an aggressive monetary stimulus program within highly interconnected capital markets, operating in a global economy. This has not been a part of the FOMC's forecast...

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The FOMC is running out of excuses to maintain current policy

The retail sales measure from the Commerce Department survey came in below expectations today with 0.2% month-over-month change vs. 0.3% expected. Given that the numbers missed the forecast, why then did treasuries sell off sharply after the release?

10y treasury yield (source: WSJ)

The answer is that while retail sales growth has not been spectacular, it is sufficiently strong for the Fed to begin reducing its securities purchases shortly. Sales ex-autos were up 0.4% (auto sales are volatile and other recent indicators of auto sales have been strong.) The year-over-year ex-auto retail sales number is historically on the lower end, but falls within the 2.5%-5% range that some view as stable.

Given that the consumer is such a large part of the GDP, some economists are already revising their GDP forecasts up. The FOMC now has only one key potential showstopper: the ultra-low inflation rate scenario.  As James Bullard pointed out in his June speech, inflation measures were collapsing earlier this year (see post), raising the specter of deflationary risks. If that trend were to continue, the Fed would go into a holding pattern.

But inflation indicators in the US seem to have stabilized. Commodity prices have bottomed out (for now), as copper bounced (see post) and energy prices remain elevated.

CRB BLS Spot Index of 23 commodity markets (source: CRB/barchart)

Moreover, market-implied inflation expectations have risen since the dip earlier this summer.

10 Year TIPS/Treasury Breakeven Rate
(implied inflation expectation; source: Ychart)

With deflation no longer a high probability near-term threat, the FOMC has run out of excuses. Unless the labor market suddenly takes a material turn for the worse this month, we should see the beginning of the end for QE3 shortly.

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Projecting the unemployment rate

Back in June, the Fed had made it quite clear that the FOMC is looking for the unemployment rate to hit 7% before fully ending the current securities purchase program. The bank still continues to be focused on this headline measure (even if it's not always a meaningful indicator of the health of the labor markets).

CNN: - If unemployment falls to 7% by mid-2014, the Federal Reserve will stop buying U.S. bonds and mortgage backed securities, he said. That's the first hard number the Fed has given for when it may end its stimulus policy, known as quantitative easing.

The July unemployment rate came in at 7.4%. The question now is - how long would it take for the number to fall another 0.4% ?

It comes as a bit of a surprise to many, but the decline in the unemployment rate since the peak in 2009 has been remarkably linear. And a linear projection puts the 7.0% unemployment rate in Q1 of next year.

That means if the Fed starts curtailing its purchases in September, the monthly reductions will need to be around $14 billion to hit that target. Of course another very realistic scenario is that the decline in the unemployment rate will slow. In that case we could see the target rate reached in Q2, 2014, making the monthly reduction requirement more gradual. What is clear is that the Fed does not want to spook the markets by suddenly ending the purchases. That makes the central bank more likely to start soon to make sure the FOMC doesn't end up with a 7% unemployment rate on their hands long before the purchases are wound down.

The 6.5% rate is supposedly the time the Fed is expected to consider raising the overnight rate. That date remains much more uncertain, since estimating the trajectory of the unemployment rate that far out is difficult to say the least. Right now the linear interpolation puts the 6.5% unemployment rate at the end of next year, while the futures market is putting the first rate hike in Q1 of 2015. That means that the futures market is not entirely inconsistent with the linear fit of the unemployment rate - even that far out.

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QE3: the act of doing the same thing and expecting different results

As we approach the first anniversary of the Fed's monetary expansion effort (QE3), it's worth comparing the success of the current program with that of 2010-11 (QE2). At this stage the two are roughly equivalent in growing bank reserves.

Note: The official start dates were a bit different but the announcements took place around the same time

In fact just in the past few weeks the QE3-induced reserve growth exceeded that of QE2, as the total bank reserves (commercial banks' deposits with the Federal Reserve banks) move above $2 trillion (and the US monetary base moves above $3.2 trillion).

The key to these programs' effectiveness is their impact on credit growth. Here is the comparison. One could presumably argue that QE2 resulted in stemming the credit contraction taking place in 2010. It's hard to make that argument for QE3.

Given this result, why would any central bank want to continue on its current path? Some would argue it is to keep longer term interest rates low. But the 30-year mortgage rate is now some 60+ basis points higher than it was when QE3 was announced. So if it's not credit growth or interest rates, what is the mechanism to transmit this "unconventional" monetary policy into the economy and job growth?

You hear economists talk about how the Fed should continue buying securities at the current pace because the US economic growth remains tepid. But isn't this simply doing the same thing (now for a year) and expecting different results?

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5 reasons the Fed's taper will begin in September

Little doubt remains at this stage that the Fed will begin slowing its securities purchases this September. The central bank under Bernanke's leadership has been highly focused on data and will consider the following 5 broad indicators to reach its decision.

1. Labor markets: As Bernanke recently pointed out, with respect to labor markets the hurdle for reducing purchases is lower than for raising rates. The FOMC will be looking for improvements in demand for labor in the US and will find it in these data:

Source: BMO Capital Markets

While the labor situation is still terrible by historical standards, it will be sufficient for the FOMC who will be looking for steady improvements. The strength in consumer confidence (see latest from U Michigan) will also be viewed as supportive of the stronger labor markets thesis.

2. Money supply: Once again the view will be that broad money supply's relatively steady growth of above 7% per year will suffice.

3. Economic activity: While a number of indicators have been pointing to less than stellar growth, the Fed will consider (among other measures) the broadest indicator, the so-called Coincidence Index of Economic Activity. The index hides numerous problems with the economy but will nevertheless be an important data point for the central bank. And based on this indicator, the US is experiencing sufficiently steady growth. To support the steady growth thesis, the Fed will also consider surprisingly strong auto purchases and factory orders data (see Reuters story).

4. Financial stress:  The Fed's own indicators point to fairly benign financial conditions. This is not surprising given the relatively tight swap spreads and credit spreads, low VIX, strong equity markets, etc.

Supporting the US data on financial stress is the ECB's "Systemic Stress Composite Indicator" (below), which has declined to near record lows. Given the impact of the Eurozone crisis on US financial markets, the Fed will clearly consider that index as well.

ECB's Systemic Stress Composite Indicator (in the Eurozone)

5. Impact on interest rates: Certainly with the Fed exiting treasury purchases, the demand for US government paper should will be reduced, pushing yields higher. But given the recent fiscal tightening in the US (due in large part to the sequester), treasury issuance is expected to decline - at least in the near term (chart below). The Fed will view this decline in the federal government's borrowing needs as counteracting its reduction in purchases and keeping rates under control in the near term.

Source: Scotiabank Economics

Obviously, an exogenous shock such as a spike in oil prices could force the Fed to hold off. Also the US legislators' failure to raise the federal debt ceiling, which Bernanke called "a calamitous outcome", could take tapering off the table.

CIBC World Markets: - Any attempts to tie a budget deal to a repealing of Obamacare could throw a wrench into discussions, while inflexibility on either side could push negotiations to the eleventh hour. And with federal borrowing pressing up against the limit, wrangling over the debt ceiling—an apparent late summertime tradition—is set to heat up yet again.
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The Fed doesn’t seem to be quite as blasé as markets are at this point about budgetary pitfalls. Bernanke recently stated that fi scal policy could “restrain” growth and the debt ceiling outcome could “hamper the recovery”. With Washington getting down to the political wire right around decision time for QE tapering, political wrangling could infl uence just how willing the Fed is to step off the stimulus pedal.

Aside from such events, the Fed is likely to shave off some $15-$20bn from its monthly purchases. With Bernanke likely departing early next year, the Fed is eager to wrap up this latest round of purchases soon and focus on the more traditional policy tools such as short-term rates and forward guidance (see discussion).

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