Some Common Cents on September 22, 2017

September 22, 2017, by John Norris

The Federal Open Market Committee (FOMC), the monetary policy making body of the Federal Reserve, met this week, and very people were concerned about what it would decide to do with the overnight lending target rate between member banks. This would be highly unusual but for the fact EVERYONE wanted greater insight regarding the hotly anticipated “unwinding” of the quantitative easing the Fed did during the aftermath of the financial crisis. In case you missed, quantitative easing is a euphemism for buying securities with money that didn’t previously exist.

Instead of recreating what others have already created elsewhere, and quite well I might add, let me cut & paste a portion of an article by Nick Timiraos in the Wall Street Journal this past Tuesday. Okay, that was the day before the FOMC released its announced, but what Nick wrote is a pretty darn good explanation of the situation.

“OK, I know the Fed accumulated the holdings by buying bonds. And I’ve read that it will shrink the portfolio by letting limited amounts of them mature, which means it will receive principal payments from the issuers. So what will the Fed do with that money?

The Fed essentially created money out of thin air to buy the bonds. Now, it will destroy the money the same way.

The central bank has been reinvesting the proceeds from maturing Treasurys [sic] and mortgage-backed securities to keep its portfolio steady at around $4.5 trillion. It will soon begin to allow small amounts of these bonds to mature without any reinvestment.

To explain what it does with the money it helps to recall how it bought the bonds in the first place. When private investors buy bonds, they use cash, borrow funds or sell assets to raise the money to make that purchase.

The Fed is different. It doesn’t have to do any of those things because it has the power to electronically credit money to the bank accounts of bond dealers who sell mortgage-backed securities or Treasurys. The Fed gets the securities, and the seller sees its account increase by the same amount as the securities’ value. The Fed isn’t literally printing paper currency to do this, but it is creating funds electronically that weren’t in the financial system before.

This process is about to go into reverse. Instead of reinvesting the proceeds of maturing bonds, the Fed will erase them electronically. It won’t be destroying any paper currency, but the money essentially vanishes from the financial system.

The New York Fed provides a detailed breakdown of the accounting on its Liberty Street Economics blog.

The Fed plans to move gradually. For the first quarter—probably to begin in October—it will allow $6 billion in Treasurys and $4 billion in mortgage bonds to roll off every month. Anything beyond those limits still will be reinvested. Every quarter, those amounts will increase until after a year, when the Fed will allow up to $30 billion in Treasurys and $20 billion in mortgages to expire without any reinvestment.

One important caveat: The Fed isn’t going to sell any bonds.”

Yep, that is an extremely good 365 word, the [sic] doesn’t count, synopsis on the matter, and I saw no real need to attempt to do any better. Trust me, this is unusual for me, so my hat is off to Nick.

However, the thing is….the Fed doesn’t have to do what it says it is going to do. By that I mean can alter its plans depending on economic, market, and liquidity conditions at the time. It won’t blindly drain, say, $50 billion out of the system each month if all hell is breaking loose in 2019 just because it said it was going to do so in 2017. Flat out, it won’t. Exclamation point and end of discussion.

You see, quantitative easing is an extreme monetary policy maneuver. This isn’t your normal, run of the mill repurchase agreement or reverse repurchase agreement. Those things have well-defined processes and/or procedures. Quantitative easing? Suffice it to say, even if the Fed has some kind of stated procedure, NO ONE will complain if it doesn’t follow it to the T.

The markets just wanted/want to know about how much the Fed was/is potentially thinking about maybe draining from the system at some point perhaps along the way. Had the Fed said “we intend to sell all of our additional bond holdings over the next 6 months come hell or high water,” that would have been one thing. But potentially not reinvesting up to $10 billion in maturities each month for a while, or something along those lines, is vague and puny enough to not cause any indigestion.

After all $10 billion/month is the interest the Fed would receive on $4.254256 trillion in debt securities at 3% interest. In other words, the Fed ain’t doing much more than letting its interest evaporate at that monthly level. Now, at upwards of $50 billion/month, it would still take close to 6 years to drain the combined effects of the several quantitative easing programs from the banking system.

Okay…okay….fair enough. I suppose the question is: why go to all this effort in the first place? I mean, the Fed created all this cash out of thin air to, seemingly, no real effect to the system. After all, inflation seems under control; the dollar didn’t collapse; the markets have done great, and the banking system would appear to be in healthier shape now than it was when the Fed started all this craziness. So, why do a dern thing? Can’t those people just leave well enough alone?

To be sure, there isn’t a lot of precedent to know just what happens when you unwind a quantitative easing program(s). While I am supposed to say things like “past performance is not indicative of future results,” I also happen to believe the past is the best predictor of the future we have. To that end, there isn’t enough “past” to venture a good guess as to just what will happen and when.

With that said, I imagine the Fed is concerned about the “excess” liquidity in the markets potentially mispricing risk, if it hasn’t already. We could debate that for hours.

The truth is, a lot of that cash the Fed created never really got off the sideline or out of the dugout, at least in terms of being “out there” in the broader economy. It got stuck in the financial system, and has sloshed about for the last several years.

However, by gobbling up all those government securities, either direct or indirect, the Fed drove down longer term interests (while keeping the short end at or near zero). Since many (if not most) types of ‘legitimate’ debt securities are somehow priced relative to US Treasury securities, an artificially low Treasury curve (thanks to Fed demand) will, presumably, lead to artificially low interest rates in the credit markets.

For instance, a BBB corporate credit might normally be priced at, say, 200 basis points off the appropriate US Treasury security (in terms of maturity). IF the Fed drives down Treasury yields through a quantitative easing program, what might happen to the yield of that BBB security? That’s right, it could very easily, and quite possibly, go down as well. As a result, “riskier” credits could end up borrowing at below normal market rates because the Fed has essentially created a “new market” out of thin air. This, then, means the Fed has, quite potentially, contributed to the mispricing of risk in the financial markets.

You can think of it this way: the Fed created a lot of money; however, the money didn’t really end up in the economy. So, household inflation didn’t go up as a result. Instead, it stayed in the financial markets, and assets become inflated instead. Therein lies much of the reason why US paper assets have performed as well as they have since the second round of quantitative easing in November 2010.

For some reason back then, the Federal Reserve didn’t think the economy wasn’t growing fast enough for its liking. So, it decided to create an additional $600 billion with which to purchase Treasury securities. Just short of two years later, it turned its attention to mortgages, and decided to wolf down eventually up to $85 billion per month. By the time the dust settled, the Fed had added about $3.5 trillion to its balance sheet….which is a staggering sum of money.

Not surprisingly, longer-term interest rates are lower now than they were then. However, perhaps a little surprising, the dollar is stronger now. Further, the stock market was up over 140% (total return) from 11/30/2010 through 8/31/2017. All this while the US economy hasn’t posted 3% GDP growth in any calendar year since 2005. As such, stock market valuations/multiples are significantly higher now than they were. No; they aren’t necessarily shockingly or alarmingly higher; however, relatively consistent 2% GDP growth probably shouldn’t engender such enthusiasm.

Basically….robust financial assets and mediocre economic activity. There is no way that hasn’t led to a mispricing of risk somewhere, anywhere, in the financial markets. HIs it any wonder why people are concerned what will happen to their portfolios when, not IF, the Fed removes some of the excess, um, slosh. You know, intuitively, a huge reason behind the markets’ strong run.

I hope this makes sense.

In the end, without a doubt, the Fed’s plan on unwinding its bloated balance sheet IS the biggest economic headline….for months, quarters, and maybe years. This week, the picture become a little clearer, and I will use an analogy: they are going to drain the excess cash out of the financial system one beer out of the 150 quart cooler at a time.

Beer out of the cooler? Yeah, it is Friday isn’t it?