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posted on 06 November 2017

The Receding Tide Of Quantitative Easing

Written by

Macro Tides Monthly Investment Outlook 06 November 2017, Part 1

The Federal Reserve initiated the rising tide of quantitative easing (QE) by central banks in early 2009. The initial goal was to stabilize financial markets. The first program of QE ended in March of 2010 and became known as QE1 after the Fed announced in August 2010 it would launch a second round of QE in November 2010.

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In September 2011, the Fed began Operation Twist, which sounds like a movie starring Frankie Avalon and Annette Funicello with music by Chubby Checker. The Fed’s version of the Twist was selling Treasury paper with maturities from 3 months to 3 years, so they could purchase Treasury bonds with maturities from 6 years to 12 years. By twisting the yield curve the Fed expected to bring longer term Treasury and mortgage yields down to help housing.

welsh.monthly.2017.nov.fig.01

After Operation Twist ended in June 2012, the Fed launched QE3 in September 2012 and allowed it to run until October 2014. By the time the Fed was done its balance sheet had grown from $900 billion in 2007 to $4.5 trillion in 2014. The Fed began to trim its balance sheet in October at $10 billion per month and will increase the monthly amount by $10 billion at the beginning of each quarter. It will cap the monthly reduction at $50 billion starting in October 2018.

In reality the Fed wasn’t the first central bank to use quantitative easing. That honor goes to the Bank of Japan (BOJ) which initiated its first QE program in March 2001 after more than a decade of deflation and no growth. However, the BOJ didn’t really get serious about QE until April 2013 when it set the goal of lifting inflation to 2.0% by doubling its monetary base within two years. Since April 2013, the BOJ has extended the date of when it expects inflation to reach 2.0% six times. If at first you don’t succeed, try, try, try, try, try, and try again.

welsh.monthly.2017.nov.fig.02

The BOJ now expects to achieve it in 2020, although they were too modest to identify which month. In September 2016 the BOJ altered its QE program to peg the 10-year Japanese government bond at zero percent, and will adjust its buying to achieve that target. In recent months, the yield on the 10-year government bond has not required as much BOJ buying and its monthly purchases have declined from $80 to $65 billion.

At the end of September, the BOJ’s $4.6 trillion balance sheet was larger than the Fed’s. The BOJ now owns 40% of Japanese government bonds and 71% of Japanese equity Exchange Treaded Funds (ETFs).

The BOJ has not announced when it might curb its QE enthusiasm and is expected to continue expanding its balance sheet by $60 to $80 billion per month for the foreseeable future.

The ECB didn’t join the QE parade until March of 2015 but has more than doubled the size of its balance sheet to $5.1 trillion as of September. On October 26 the ECB announced it would reduce its monthly purchases in January 2018 from $60 billion to $30 billion a month, but extended its QE program through September 2018. The ECB also kept its policy rate unchanged at minus -0.40% and said it would maintain negative interest rates well past the end of its QE program.

welsh.monthly.2017.nov.fig.03

During the fourth quarter the Fed will shrink its balance sheet by $30 billion, but that will be offset by an increase of $180 billion in the ECB’s balance sheet and the BOJ’s increase of $270 billion. In total the big three central banks’ balance sheet will expand by $360 billion.

However, after the ECB reduces its monthly purchases from $60 billion to $30 billion in January and the Fed increases its monthly cuts from $10 billion to $20 billion, the quarterly expansion in central banks’ balance sheet will fall to $240 billion in the first quarter and to $210 billion in the second quarter.

If the ECB cuts its monthly purchases from $30 billion to zero starting in the fourth quarter of 2018, (a big assumption given Mario’s penchant for QE), the quarterly expansion will be just $60 billion, if the BOJ maintains it monthly purchases at $70 billion.

welsh.monthly.2017.nov.fig.04

Although central banks’ balance sheet will expand in the fourth quarter, the rate of increase will fall by 33% in the first quarter of 2018 and by more than 80% by the end of 2018. The growth in central bank balance sheets as a percent of GDP peaked in the first quarter of 2017 at 3.7%. By the end of 2017 the percent will fall to 2.3%, before dropping sharply throughout 2018.

The deceleration in central banks’ QE has the potential to upset financial markets since stocks and bonds have been the primary beneficiary.

welsh.monthly.2017.nov.fig.05

If Congress does pass some form of tax reform, the deficit is likely to be larger in the short run, since it will take time for economic growth to accelerate enough to generate higher tax revenues. On October 26, the House passed a budget bill that authorizes a $1.5 trillion increase in deficit spending over the next decade. An analysis from the Bipartisan Policy Center that adds new disaster relief spending and the costs of GOP tax-cut plans to earlier projections from the Congressional Budget Office found the deficit could reach $1 trillion as early as 2019 - four years earlier than the CBO calculated in January.

For the fiscal year ending September 30, 2017, the U.S. had a budget deficit of $668 billion.

welsh.monthly.2017.nov.fig.06

In the fourth quarter of 2017, the Fed will pare its holdings of mortgage paper by $12 billion and Treasury bonds by $18 billion. In the first quarter of 2018, that will double to $36 billion, rise to $54 billion in the second quarter, $72 billion in Q3, and $90 billion in the fourth quarter. In total the Fed will reduce its holdings of Treasury bonds by $252 billion in 2018 and $360 billion in 2019, or roughly 1.25% of GDP in 2018 and 1.8% in 2019, which seems like a drop in the bucket. But the more appropriate comparison is to the amount of the annual deficit since that is what needs to be financed. If the 2018 deficit is $600 billion (my guesstimate), the $252 billion reduction in the Fed’s balance sheet amounts to 42% of the deficit and 51% of the deficit in 2019 if the deficit in 2019 is $700 billion (my guesstimate).

The bond market in 2018 will have to finance the $600 billion deficit and another $252 billion to absorb the reduction in the Fed’s holdings. And if the 2019 deficit is $700 billion, the true amount to be financed will exceed $1 trillion ($700B deficit + $360B Fed).

If the estimate by the Bipartisan Policy of the deficit exceeding $1 trillion in 2019 materializes, the amount the bond market will have to finance could approach $1.4 trillion. The potential for an imbalance to develop between supply and demand in the Treasury market sometime during 2018 and 2019 could put upward pressure on interest rates just to attract more demand. This kind of imbalance could lead to a spike in yields.

Click for large image.

welsh.monthly.2017.nov.fig.07

The 2016 low in the 30-year Treasury bond yield was 2.10% and the high in March 2017 was 3.20%, an increase of 1.10%. In September the yield bottomed at 2.65%. An equal increase of 1.10% from this low suggests the yield on the 30-year Treasury bond could reach 3.75% during 2018, which isn’t much below the high of 3.97% in 2013. If there is equality in time, the high in the yield should occur about 9 months after the September low or in June 2018.

ECB and European Yields

The Eurozone economy has been picking up steam over the past three years. GDP growth has been hovering near 2.5% since the fourth quarter of 2016 and at the highest level since 2011. During 2015 and 2016, inflation was holding near zero percent. During the last year, inflation as measured by the consumer price index jumped to 2.0% before slipping back to 1.4% in October.

welsh.monthly.2017.nov.fig.08

Economic Sentiment is more positive now than at any time since before the financial crisis as is consumer confidence.

welsh.monthly.2017.nov.fig.09

welsh.monthly.2017.nov.fig.10

In response to the rising tide of optimism, retail sales have shown consistent improvement during the past year in the five largest countries as measured by GDP. This indicates that the improvement is broad based as opposed to being primarily due to strength in the German economy as it was two years ago.

welsh.monthly.2017.nov.fig.11

The ECB’s decision to extend its QE program through September with $30 billion of monthly bond purchases and keeping its policy rate at -0.40% allowed in bond yields to fall throughout Europe. Since the announcement, the yield on the 10-year German Bund has fallen from 0.48% to 0.37% on November 2. The spread between the yield on 2-year German government bunds and U.S. 2-year Treasury bonds is the widest since 1999.

welsh.monthly.2017.nov.fig.12

Like a stretched rubber band something’s got to give. In the short term, yields in the U.S. are not likely to move above the highs in March, when the 10-year Treasury yield reached 2.62% and the 30-year topped at 3.20%, until yields in Europe increase. The ECB’s level of accommodation is not justified by the improvement in the broader Eurozone economy and increase in inflation. Savers, especially in Germany, are likely to grow increasingly impatient with negative rates.

If the Eurozone economy continues to grow near 2.5% in the first quarter of 2018 and inflation holds near 1.5%, the pressure on the ECB to reduce its monthly purchases will mount. The yield on junk bond yields in the Eurozone dropped to 2.03% last week, while the yield on 10-year Treasury bonds was 2.35%. Even Mario should be able to recognize that the European bond market is being distorted by the ECB’s monetary policy which is increasingly out of touch with reality.

welsh.monthly.2017.nov.fig.13

Two closes above 0.50% on the German 10-year Bund would suggest an increase in European yields is developing that should also lift Treasury bond yields.


Part 2 follows tomorrow: Selling Tax Cuts, Whither the Fed, and the Future for Stocks


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