Tuesday 10 October 2017 by Craig Swanger Opinion

Unwinding of QE – dispelling the myths

The long talked about unwinding of QE – known as QT - is finally here, at least for the US.  Markets took the announcement in their stride without the “taper temper” volatility seen over the past few years on policy changes, thanks to the Fed drip feeding the news over the past year.  But what does it actually mean for interest rates, the USD and the global economy?

QE

Source: charlotteobserver.com

How did we get here?

In response to the GFC, central banks around the world eased interest rates to near zero in many cases and then effectively eased policy even further using the then unprecedented “Quantitative Easing” (QE).  QE involved the central bank buying securities, typically government bonds but often other fixed interest securities or even equities.  That buying supported low long term interest rates, encouraging borrowing and thus business and household investment, nursing the economy back to health.  Or so the theory went.  In practice the results were mixed.

In the US, were the Fed responded immediately and aggressively, the economy recovered first.  Similarly in the UK.  In the EU and Japan, where they waited longer, and arguably the economies were weaker to start with, it is hard to tell whether QE had the same impact. We’ll never know how bad things could have been, but those economies will remain in need of QE stimulus for some time yet.  

Impact of QT on US bond prices

The first critical thing to understand about QT is that the Fed will not actually be selling bonds.  They will reduce debt by letting bonds mature and not replacing them. 

The second critical point is that while the balance sheet of the Fed grew by $3.7 trillion during the GFC’s QE process, because of the additional liquidity now in the economy, the Fed must keep additional assets on its balance sheet.  This means that the actual reduction will likely be around $1.7 trillion. 

This is still a meaningful percentage of the overall market.  Securities worth $1.7 trillion will need to be taken up by other buyers, representing around 13% of the US mortgage backed securities market and 7% of the treasuries market.  But as this is over a four to six year period and should not cause any meaningful change in prices. Any change is probably already priced into markets given that this has been well flagged over the past year.

Impact of QT on Fed interest rate moves

With the Fed tightening conditions with two mechanisms at once and a short term desire to remove QE, there is a strong argument that QT will actually lead to lower interest rates, not higher.  All other things being equal, both QT and an expectation of higher cash rates support bond yields and run the risk of pushing rates up when they work in combination.  And that is exactly the reason why the Fed will be very careful not to suffocate the economic recovery by doing too much tightening overall. 

The argument for higher rates as a result of QT is that the Fed selling assets will push down bond prices (thereby pushing up yields), but the above analysis shows why this is a weak argument.  There is no “selling” of bonds by the Fed; the volume is much lower than some analysts are saying; the pace is very moderate; and QT’s timing has been well flagged and therefore probably priced in already.

More likely is the scenario where QT is used as the throttle for tightening conditions, and delaying cash rates is used as the brake.  That is, the argument for lower rates suggests that the Fed will stay the course on QT but if the economy shows signs of weakness, it will slow the raising of cash rates.  With the rest of the world still struggling to pull out of extremely low inflation and reignite economic growth, and the US growth itself well below normal economic recovery levels, there is significant risk that the Fed will be forced to be very patient in raising cash rates while QT continues.

QT and rates tightening in the context of low inflation environment

There is an even stronger argument for rates continuing to surprise on the downside when looking at the broader economic context where inflation is being held down by the digital economic revolution.

Conclusion

At the risk of sounding like the proverbial stuck record, the conclusion is still “lower for longer”.

So long as markets continue to believe QT will result in an oversupply of bonds in the market thereby pushing down bond prices (yields up), there will remain opportunities to take a long term position.  That said, at the current 10-year bond yield of 2.34%pa (as at 2 October US time), this is around fair value in my view.  Three weeks ago yields almost dropped as low as 2%pa on the flight to safety due to the North Korean tensions.  That level is too low in the current context, particularly with continuing US economic strength. 

It is likely that over the next few months, US ten year yields will oscillate between 2.1% and 2.5%pa , so investors following the argument above should look to lock in higher yields when they come, depending of course on whether good value can be found in the corporate bond spreads and currency at the time.



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