Sunday, July 7, 2013

Of tapers and feral hogs

As readers of this blog will know from my previous musings on the Federal Reserve ( - see here), the Fed responded to the downturn in the economy during the last recession and consequent sluggish growth this engendered, by stimulating the economy using a variety of unconventional monetary measures as interest rates approached their lower bound, in other words zero.

This was an unprecedented experiment in stimulating the economy by a variety of measures, including buying government bonds in various proportions along the yield curve (at a variety of different maturities) to force interest rates down ("Operation Twist"), as well as unprecedented purchases of non-government paper, such as "Mortgage-Backed securities" (MBS) which are essentially bundled together mortages. This latter measure is known as "Quantitative Easing" of QE.

In fact there were three phases of the Fed's QE measures as follows:

i) QE1 - In late November 2008, the Fed started buying $600 billion MBS. By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing as rapidly as they wanted. After the halt in June holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012. The Fed's revised goal became to keep holdings at the $2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2–10-year Treasury notes a month.

ii) QE2 - this was initiated in November 2010 when the Fed announced plans to buy $600 billion in long-term Treasuries, in addition to the reinvestment of an additional $250 billion to $300 billion in Treasuries from earlier proceeds from mortgage-backed securities.

iii) QE3 - A third round of quantitative easing, QE3 was announced on 13 September 2012. In an 11-to-1 vote, the Federal Reserve decided to launch a new $40 billion a month, open-ended, bond purchasing program of MBS. Additionally, the FOMC announced that it would likely maintain the Fed funds rate near zero "at least through 2015." On 12 December 2012, the FOMC announced an increase in the amount of open-ended purchases from $40 billion to $85 billion per month.

Earlier this month the Chairman of the Fed hinted in testimony before Congress that the Fed would consider tapering QE ( - so scaling it back), and after Friday's good employment figures yields on bonds shot upwards, signifying that we are now nearly at the point where there have been consistent additions of around 200,000 workers per month to the non-farm payrolls, but due to people coming back into the Labor force because of the better conditions, this has caused the unemployment rate to get stuck at just over 7.5%.  Other heads of central banks (such as the newly installed Mark Carney of the Bank of England) said on Friday that interest rates will not be ramping up in their jurisdictions, but that didn't stop bond rates in their countries from spiking. The Fed has of course said that it will keep short rates at near zero until the unemployment rate has fallen to 6.5 per cent, subject to projected inflation remaining under 2.5 per cent. One way of forcing home the message that this will not happen soon would be to reduce the unemployment threshold to 6.0 per cent, but I think that this is unlikely, as I think the Fed now wants to exit from QE.

So what can we expect will happen from now going forward?

Source: Wall Street Journal
First, let's remember that "tapering" is not tightening monetary policy.  Tapering simply means that an easy monetary policy gets easier at a slower rate.  The reversal itself isn't expected until 2015 at the earliest, so that's 18 months away.  That's an extremely positive situation for stocks and economic growth, so the stockmarket should continue on an upward trend and those employment numbers are likely to get better and not worse.  Althought the unemployment has not fallen fast enough for some, it has definitely been falling, as the figure below shows.

Second, what about the balance sheet of the Fed?  Obviously buying all these MBS and Treasury bills and bonds will undoubtedly have swelled the balance sheet and this will clearly have to be undone.  But that will be fairly easy for the shorter-term bonds as once they reach their maturity dates, the Fed will basically not roll them over and will collect the cash payment that is made for any dated financial instrument.
Fed's Balance Sheet (Assets)
Source: Federal Reserve Board
What is interesting in the chart is how aggressive QE3 has been, in the way the purchases of securities are clearly seen going up in step increases since 2012 at a rate that is clearly faster than any previous stimulus with the exception of the beginning of QE1.

As can be seen, the balance sheet of the Fed will need to shrink back from over $3.5tr back to less than $1tr in order to completely reverse the effects of QE1 to 3 on the economy.  That will take at least $2tr out of the economy, which represents about 15.6% of US GDP right now, which is a sizeable amount of liquidity.  That will clearly either cause inflation to rise if left in the economy for an extended period of time, or will push interest rates up back to normal levels or perhaps beyond normal levels if the acceleration in economic growth is significant.

Looking at the issue from this perspective it is understandable why bond yields have shot up on 2 occasions, despite the accusations coming from Fed officials such as my local Fed District President, Richard Fisher (see here), that markets are acting like "feral hogs" by testing whether Fed policy to continue easing can be sustained into next year. Fisher said “Markets tend to test things. We haven’t forgotten what happened to the Bank of England [on Black Wednesday]. I don’t think anyone can break the Fed . . . But I do believe that big money does organise itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”

Third, the Fed has really been the best friend of the stockmarkets in recent years.  But when we consider the Fed's actions and their impact on the markets, we have to keep a few things in mind.  First, this is an unprecedented loosening of monetary policy, and eventually it has to come to an end, so interest rates have to rise, whatever happens.  In fact, I would suggest that they will probably overshoot where they should be in the long run simply because the stimulus has been so significant and because the Fed probably will reverse the loosening of monetary policy at the long end at a more rapid pace than people expect simply because they need to get these long interest rates back to something approaching normality.  That means that "operation twist" will be the first to be unwound, so that the Fed can also keep it's promise to make sure short rates stay low until the economy has finally reached "escape velocity" again.

So although interest rates have ramped up already at the long end, how much further do they have to go?  Well we can look at 2 perspectives on this.  First, look at a 5 year plot of US bond rates to see what has happened in recent weeks ( - but not including last Friday's hike in rates).  The blue line is the 20 year bond yield and the 10 year bond yield is the 10 year bond yield.  The difference between the yields is shown in the thin grey line at the bottom of the chart.  What is apparent is that rates need to go back to roughly 4.5% to 5.5% before we are in more normal territory for long term bond yields (with low rates of inflation), and we are only in the 2.5-3.5% range right now.

The point being that although Fed officials might be correct in pointing out that the ramp up in rates recently is a little overdone considering that the Fed hasn't started tightening yet, markets do not care for current conditions, they are forward looking and want to incorporate future moves in monetary policy.

So what about really long rates and the prospects in terms of where they should be.  In the figure below I plot both 10 year and 30 year bond yields for the last 5 years to show how bond prices have changed for these two financial instruments since July of 2008, when bond yields (from the chart above) clearly started to react to QE.  As of last Friday 30 year bond yields were still about 20% below where they were 5 years ago and 10 year bond yields were 30% below where they were back then.

Note that the increase in rates necessary to get back to where we were 5 years ago is still significantly below the usual level for long bond yields, and that there may be some overshooting as well, particularly if inflation picks up once the output gap in the economy is closing. So once the Fed's monetary policy is unwound, it implies a large increase in long rates and perhaps as much as a doubling of these long bond yields from where they are currently.

The chart below shows that in fact inflation expectations have been falling, despite the large injection of money into the economy.  This is to be expected according to Keynes, as any student of monetary theory knows, but once the increase in money supply does it's work and stimulates economic growth, inflation will inevitably start to pick up again ( - in fact the chart seems to suggest that expectations are currently bottoming), which implies higher nominal interest rates as well.

So the stage is set.  The only big unknown is who Ben Bernanke's successor will be and what their opinion is of the current monetary policy stance.  I would hazard a guess that President Obama will be unlikely to pick an unknown quantity to take up the reins once Bernanke goes, and my guess would also be that that person is likely to be more of a "dove" than a "hawk" on the FOMC.  So in other words the process of tapering and then tightening might actually take longer than expected.

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