he foggiest place in the world is believed to be the Grand Banks, a body of water off the coast of Newfoundland, Canada. It is not far from where the Titanic sunk in 1912, making it a haunting place even without the chilly air and the fog painting everything a dark and dismal gray. In a seeming paradox, the Grand Banks is also teeming with an abundance of life, making it one of the best fishing spots in the entire world and drawing in anglers from all over no matter the gloom. Those who choose to enter the Banks must take care navigating their vessels.
Navigating through a dense fog of risks and uncertainties, investors too can easily be veered off course from their objectives and thrust into the many veritable icebergs that hide behind the fog. Acting prudently, however, like the fisherman in the Grand Banks, will enable investors to net their bounty.
Sometimes markets lead the Fed. This time they can’t because the complexities surrounding the reversal of the Fed’s current policies are too great; the reversal isn’t as simple as the Fed pulling its interest rate lever. Many unconventional policies are still in place, not the least of which is the enlargement of the Fed’s balance sheet, which has grown substantially as a result of the Fed’s long-term securities asset purchase programs, dubbed QEI and QEII, as shown in Figure 1.
Based on its recent actions and communications, the Federal Reserve clearly recognizes that it must make clear the route it will take when it decides to reverse its current policy stance. The Fed is concerned about the collateral damage that could occur in the financial markets from any reversal of its policies. It is one of the reasons the central bank, for the first time in its 98-year existence, this year has begun holding press conferences following its regular meetings.
To further clear the fog, the Fed, in the minutes to its April meeting, detailed what to expect when a policy reversal has been decided. We still don’t know the “when,” but we have much greater clarity on “how” the Fed will exit. Both are necessary to navigate the fog, but the “when” is something the markets are apt to figure out on their own in addition to the Fed signaling well in advance.
Seeing the Exit Strategy Through the Fog
Ever since Federal Reserve Chairman Ben Bernanke held his first press conference on 27 April, a consensus has been building around what sort of actions investors should expect when a policy reversal is commencing. Again, without clarity, investors will be lost in the fog, and the risk of collateral damage would be high. More than clarity is needed, however.
The consensus that has developed in recent weeks centers on the sequencing of steps the Fed will take when it reverses course, and the amount of money the Fed will need to drain from the financial system to gain control of the federal funds rate, the Fed’s preferred interest rate tool. The Fed has lost control of the rate because of the vast amount of money in the financial system, relying instead on the interest rate it pays on excess reserves (0.25%), which is meant to act as a floor for the overnight rate but hasn’t because of the sheer volume of excess money that exists in the financial system, as well as technical factors related to liquidity held by the nation’s large government-sponsored enterprises.
The thinking is that the central bank will have to drain $1 trillion of the roughly $1.5 trillion of excess reserves currently in the financial system if it is to bring the federal funds rate up to the interest rate paid on excess reserves. The consensus view is that the Fed will do this with the following sequence of policy actions:
- End the reinvestment of mortgage payments the Fed receives for the mortgage securities it holds. Currently the Fed is investing these mortgage paydowns in Treasury securities in order to keep its balance sheet constant.
- Drain excess bank reserves via reverse repurchase operations. In this operation, the Fed lends securities and receives cash as collateral, draining reserves.
- Drain excess bank reserves via a term-deposit facility, whereby banks compete for a deposit rate and then deposit monies at the Fed.
- Raise interest rates, including the federal funds rate and the interest rate paid on excess reserves.
- Sell securities the Fed holds on its balance sheet.
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 Classes
We 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.
The Reinvestment Strategy
Before the financial crisis, the asset side of the Fed’s balance sheet consisted mostly of Treasury notes and bills – about $800 billion in total – and these were largely shorter-term maturities of three months to two years. Since quantitative easing began in November 2008, the composition of the Fed’s balance sheet has changed and with that also the composition of its Treasury portfolio. When U.S. Treasury purchases started in March 2009, the maturity distribution of the Fed’s Treasury portfolio changed from shorter- to longer-dated securities.
Lengthening the maturity of the Treasury portfolio became a more specific strategy in August 2010, when the Fed decided to reinvest its mortgage-backed securities (MBS) paydowns into mainly two- to 10-year Treasury notes, which continued throughout QEII alongside outright purchases.
As a result of these activities, the Fed’s Treasury portfolio currently has about $400 billion of its holdings centered on the five- to seven-year current maturity range. Now that the Fed’s Treasury portfolio has become so large – likely over $1.5 trillion by the time QEII ends – the principal and coupon payments of its Treasury holdings are estimated to be as much as $25 billion per month in the year ahead. In addition, the year-end projected MBS paydown is $10 billion to $15 billion per month conditioned upon prepayment speeds (see Figure 2).
Although the Fed has indicated eventual first steps toward normalizing monetary policy via halting reinvestment of the principal payments, with the economy on a slower path while the private sector continues to reduce its debt, the need for reinvestment of the Fed’s portfolio remains. The April FOMC minutes revealed that reduction of principal reinvestment would be for agency and MBS securities first and soon thereafter Treasury securities.
This sequencing of reinvestment may imply a differentiation strategy. Depending on the speed of the economic slowdown, the Fed could decide to keep a level of discretion over when and what will be reinvested. The Fed used such discretion last year, when it announced it would reinvest principal payments into U.S. Treasuries rather than MBS or other securities. Such a differentiation strategy could continue after QEII ends: for example, by reinvesting principal payments into only longer-maturity Treasuries (10-year and longer) than the current average maturity of its portfolio (about six years). In the process, by keeping the longer-dated component of its Treasury portfolio more or less constant, the Fed could use such reinvestment differentiation as a signal of its intent to keep longer-term rates lower if the economy remains on a sluggish path.
This interpretation of the Fed’s intent subscribes to the “stock view,” where the size and composition of the Fed’s portfolio is what matters, rather than the actual purchases. As the Fed’s portfolio is fully transparent, lengthening the average maturity can provide a powerful signal to broader asset markets and thereby influence longer-term inflation expectations. Moreover, given the Fed’s medium-term objective to hold only Treasuries in its portfolio, a reinvestment strategy based on differentiation may be an alternative to re-engaging more asset purchases.