Tony Crescenzi, Ben Emons
Keep in mind that the start of the sequencing will contain an important signaling effect that itself would cause financial conditions to tighten and slow any “need for speed.” In other words, the speed of tightening should not be solely judged by analyzing the gap between the effective fed funds rate and the fed funds target; financial conditions in their totality must be considered. The drain of a single dollar will signal a reversal of policy and thus have a major bearing on financial conditions and the speed of Fed tightening. This is another way of saying the marginal effect of the early stages of tightening will be greater than in the latter stages.
Another View: The Biggest Buyer Leaves the Store But the Trucks Keep Coming The most recent Global Central Bank Focus discussed the implications of the end of QEII and the need for the Fed and the Treasury to “make the donuts” to entice buyers to fill the void left by the central bank when it ends its buying at the end of June. Another way to look at – and understand the implications of – the end of QEII uses a department store as the setting.
Picture a store today where a few customers are inside waiting for new wares. A truck is outside – it’s the Treasury truck, and it is back again to unload a fresh supply of Treasuries to refill the store’s emptied shelves. The store’s biggest customer, the Fed, quickly grabs about 70% of the supply. The remaining buyers compete for the scraps that are left.
Mind you, the store’s biggest customer before the Fed entered the store was the rest of the world – the world’s central banks, that is. They tend to purchase about 50% of what the Treasury truck delivers, and their demand is fairly constant owing to the large amount of dollar reserves they accumulate as a result of global trade. There are other fairly consistent buyers, including pension funds, insurance companies, and commercial banks, which collectively own close to 15% of Treasuries. Doing the math, it is easy to see why the remaining buyers have been willing to pay up to own Treasuries – the Fed’s ultralow rate policy has left them with slim pickings worse than the scramble by people piling into a Wal-Mart on Black Friday at 3 a.m. to fill up their carts before others do.
Fast forward to 1 July. The biggest customer with the fattest wallet leaves the store. There is a modest “flow” effect, but prices aren’t immediately affected, because the “stock” effect is still very present, with the Fed having cleaned out most of the goods. The remaining buyers therefore dash to the shelves and scurry to buy whatever the Treasury truck delivers. As the days pass, the Treasury truck keeps on backing into the store to deliver a fresh supply of Treasuries as it must because with a $1.4 trillion budget deficit, there are a lot of Treasuries to unload. Soon enough, the shelves fill up and the stock effect becomes a negative for prices, all else equal of course, and so long as that biggest customer stays out of the store.
QEII’s Impact on Broad Asset ClassesWe have focused thus far on U.S. Treasuries, but we can’t forget that the department store contains many, well, departments, which is to say there are more items in the store than just Treasuries. The bond market is a $90 trillion marketplace, after all. Moreover, a key objective of QEII was to prod investors into those other asset class “departments,” including corporate equities, corporate bonds, foreign bonds and foreign currencies, to name a few.
In considering the impact that the end of QEII will have on other asset classes, it is essential to recognize that QE is actually a misnomer. The Fed has not actually engaged in quantitative easing. Fed Chairman Ben Bernanke and others at the Fed have tried in vain to prevent the characterization. They would rather say the Fed has engaged in a long-term securities asset purchase program (LSAP) designed to promote a so-called portfolio rebalancing effect, which is to say, to create an interest rate environment so onerous and repressive that it increases the attractiveness of other asset classes. This is why Ben Bernanke has cited the stock market when mentioning the benefits of its securities purchase program. For the Fed’s purchase program to be a true quantitative easing program, it would have to spur the creation of new money supply, which it has not, because the money, or reserves, injected into the banking system are not being lent out. Only banks can create money supply with the reserves the Fed creates.
Another major objective of QEII is to lower interest rate volatility and in so doing reduce the amount of yield premium that investors demand as compensation for future volatility, a major component of the term premium affecting the level of longer-term interest rates. QEII lowers this expected volatility in two ways. First, it sends a resounding signal that interest rates will be kept exceptionally low for an extended period. Second, it lowers the effective level of the federal funds rate. Not the actual federal funds rate, mind you, which is normally the main determinant of the degree of monetary accommodation, but the rate implied by the size of the Federal Reserve’s balance sheet, which itself is a form of monetary accommodation.
With these two major elements of QEII in mind, we can form an expectation about what’s next for the performance of the non-Treasury segments of the bond market as well as for other asset classes. In addition we can make assumptions about future market volatility.
Beginning on the outermost reaches of the risk spectrum and working inward, it is likely that over time the attractiveness of these assets will wane. Investors eventually will demand a higher risk premium in these assets to compensate them for numerous risks, including the risk that the Fed will at some point begin to contract its balance sheet and thereby impart monetary tightening upon the financial markets and the real economy. Keep in mind the effective federal funds rate is estimated at -2.50% on the notion that each $600 billion of increase in the Fed’s balance sheet equates to about 50 basis points in the federal funds rate, which is pegged near zero. This means that even if the Fed were to begin to contract its balance sheet – an event that is still many months or quarters away – the effective rate would still be very supportive of risk assets, which means that the increase in risk premiums will be more a process than an event.
The U.S. dollar for its part will remain hampered by unattractiveness of real interest rates in the United States, which, while on the rise, are likely to remain unattractive for quite some time owing to the Fed’s need to keep interest rates low to help facilitate the deleveraging process. Moreover, the massive U.S. budget deficit is likely to be a major driver of global cash flows for years to come, limiting the ability of the U.S. to grow faster and remain competitive, thereby keeping the U.S. dollar under downward pressure. Diversification out of U.S. dollars will likely be a major objective of the world’s central banks for years to come.
With respect to market volatility, it is important always to view the federal funds rate as a firm anchor for the entire yield curve. So long as the anchor is down, the ship won’t go very far. For example, at no point in the past 30 years has the U.S. 10-year Treasury yielded more than four percentage points above the federal funds rate. Still, the end of QEII means that those passengers in the financial markets who have enjoyed the stability of their voyage aboard QEII will have to face the waters in a different and almost certainly less sturdier ship, which will require them to get their sea legs to handle the added volatility.
Indeed, the Fed’s policies and its fat balance sheet are playing a powerful role in shaping financial and economic conditions around the world. An examination of this phenomenon from Ben Emons follows.
Past performance is not a guarantee or a reliable indicator of future results. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. The value of fixed income securities contained in the fund can be impacted by changes in interest rates. Bonds with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise.
This article contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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