THE MARKET’S OBSESSION WITH THE FED & QE

By David Schawel, CFA, Economic Musings

Every passing speech by chairman Ben Bernanke or release of the latest Fed minutes comes with the increasingly obvious reality that the market is 100% fixated on the Fed.  This assertion is less than shocking but important when you ascertain the ramifications of future monetary policy outcomes.

Is more QE needed? This is the question that I don’t claim to know and glad I don’t need to answer.  What I do know is that the Fed has already gone down this road as their main form of monetary easing.  Before I posit the implications of no new asset purchases or asset sales, let’s review what has happened thus far.

Mechanically, the Fed has purchased ~15% of the $5.5trillion Agency MBS market in addition to US Treasuries.  These bonds were sent to the Fed, and the Fed paid the sellers of these bonds with newly created reserves, also referred to as “printing money”.   So a large % of the systems risk free bonds were sucked out of the system and replaced by “excess reserves”.  Implications of QE?

1. Financial Repression – this term which has been adopted by Wall Street strategists such as David Zervos & Harley Bassman essentially means that the Fed has been effective in terms of lowering short & long term interest rates and reducing income to banks, pension funds, endowments, insurance co’s and savers galore. Everyone can see record low rates in almost every fixed income class.

2. Increase Disposable Income for Americans-  Driving down primary mortgage rates (for those who qualified) obviously had an impact of transferring income from MBS holders directly into the pockets of borrowers who could refi at substantially lower rates.  Millions of homeowners have dropped their mortgage payments by hundreds of dollars per month.  This was by no means perfect (see HARP failures etc), but at least beneficial for some.

3. Increase Wealth Effect / Prop up Asset Prices-  Buyers of Agency MBS & Treasuries have been pushed into IG Corporates, High Yield, Muni Bonds, Non-Agency MBS, and all the way down the spectrum.  When 15%+ of a major asset class is bought out of thin air, these former holders need to go somewhere. All attempts have been made to drive investors into risk assets, this is clear and indisputable.  BTW, ever look at a chart of gold compared to the Fed’s balance sheet? Striking resemblance.

What happens if the Fed Sold Bonds?  Let’s pretend inflation was running higher and unemployment had come down notably.  The Fed wants to drain excess reserves, and they begin to sell bonds.  Reserves get sent back to the Fed (aka money burning!), and bonds get sent back into the market.  Supply of Agency MBS and UST’s is greater and prices begin to fall/yields rise.  After all the supply has increased overnight and it needs to be filled by someone.

Now the incremental demand that has flowed into risk assets can just as easily leave that asset class.  Let’s assume the impact of the Fed selling bonds caused mortgages & treasuries to rise by 200bps.  So 30yr current coupon MBS that were trading for 3% were now up to 5%.  Would buyers of non-agency MBS at 6% or high yield at 6% rather stay in these credit assets or take a comparable yield with an explicit government backing?  The major point here is that the Fed has done a spectacular job in driving up asset prices in risk free assets (Agency MBS, Treasuries) causing risky assets to appear attractive.  Nevertheless, this relationship works both ways and is dependent upon the Fed maintaining the size of their balance sheet.  A reversal of this would deflate the asset prices just as quickly as they rose.

I don’t believe the Fed will sell bonds.  In fact it would create a rush to the exit of epic proportions.  It is for this reason that the Fed has tested reverse repo’s to see if it would be able to remove liquidity from the system.  Should the Fed stop re-investing runoff from the Agency MBS portfolio it would be a slow removal of excess reserves.  As the MBS prepay, reserves would be sent to the Fed and drained from the system.  This is the most likely, but is still probably a year or two away.

Conclusion: I believe the Fed is in a difficult position.  They cannot realistically sell bonds if the economy heats up.  They are essentially “all in”.  Now what happens if rates continue to back up as the market believes that Bernanke’s “promise” of rates low until 2014 will not be upheld?  The market has enjoyed the benefits of the Fed propping up risky assets, and at the current time appears to be forgetting about this aspect.  There is real risk to prices across the spectrum when participants realize that this sugar high might not be returning.

Even beyond asset prices, can the economy handle rising interest rates?  Housing affordability is already at an all-time high, but would a 75bp rise in rates start to choke out this housing recovery from higher primary mortgage rates?  Would Bernanke & Co be okay with a slowly improving economy if the equity markets sold off from a lack of additional QE?  We know QE has had a large impact but its clearly uncertain how a recovering economy will react without an additional dose of this accommodation.  Will the economy flourish without these “training wheels” or will it veer off course?

David Schawel

Economic Musings was founded by David Schawel. David is a husband and father of two living in Raleigh/Durham NC. He currently works as a fixed income portfolio manager. He spent time in NYC in both investment banking and equity research. He is a current CFA charterholder.

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  • theta

    “The major point here is that the Fed has done a spectacular job in driving up asset prices in risk free assets (Agency MBS, Treasuries) causing risky assets to appear attractive. Nevertheless, this relationship works both ways and is dependent upon the Fed maintaining the size of their balance sheet. A reversal of this would deflate the asset prices just as quickly as they rose.”

    I guess the key here is relative prices. Risky assets are relatively attractive now, hence they are more bid than they “deserve”, but this still hasn’t driven them to all time highs. SPX is still below 2007 levels. Similarly in the recovery scenario risky assets will become relatively unattractive and will rally less compared to what they would have, had it not for QE. So, for example, as the economy improves and company profits rise significantly, instead of SPX rallying 30%, it will only rally 10% or remain flat at the top. Hardly a disaster.

  • percolator

    If you’re using the NAR Housing Affordability Index its worthless http://www.ritholtz.com/blog/2008/08/nar-housing-affordability-index-is-worthless/

    See also housing is still not affordable: A reality check http://www.ritholtz.com/blog/2012/04/home-affordability-reality-check-part-2-of-5/

  • Frenchy

    Cullen I am interested in your opinion on this, particularly given the scenario of an improving US economy and consequently a pick up in inflation. What would the Fed be more inclined to do if raising rates appears risky for the stock market?

    Kindly,

  • http://modeledbehavior.com Karl Smith

    Its not immediately clear to me that the Fed could not sell off all of the bonds. A one day dump might be problematic but stretching it out should do fine. I haven’t seen simulations on how fast you could do this, but I am betting if you manage expectations and the Funds rate you could run the whole thing down in less than a month with little perceptible change in yields.

    The simple reason is that the price of liquidity is set by the funds rate and the Fed is infinitely elastic at the Funds rate. As the yield spread between long bonds and the Funds rate rises, banks will attempt to shift out of the funds market but the Fed will create new reserves until the Funds rate comes back down. This ultimately pulls down the entire curve.

    Yes, there can be some technical issues with trying to move several trillion dollars in one day, but stretched out it should be no problem.

  • Ben Wolf

    “Housing affordability is already at an all-time high, but would a 75bp rise in rates start to choke out this housing recovery from higher primary mortgage rates?”

    What housing recovery?

    “Would Bernanke & Co be okay with a slowly improving economy if the equity markets sold off from a lack of additional QE?”

    We already have a slowly improving economy. I think the question answers itself.

    “We know QE has had a large impact . . .”

    ???????????????????

    “The market has enjoyed the benefits of the Fed propping up risky assets, and at the current time appears to be forgetting about this aspect. There is real risk to prices across the spectrum when participants realize that this sugar high might not be returning.”

    The market is stone stupid. It gets all atwitter at the thought of the Fed swapping money for other money. Didn’t we already go down this road where less-than-well-informed traders went out and bought equities when they heard the Fed was printing money? Are we really going to do this again?

  • http://www.pragcap.com Cullen Roche

    Why would they even need to do this though? With IOR there’s no big rush. The Fed will most likely hold most of this to maturity and just let it run off the books….They can raise the FFR by raising its de fact IOR. No problem there.

  • http://modeledbehavior.com Karl Smith

    Cullen:

    There seems to be concern about the Fed’s balance sheet and what will happen if IOR rises above the yield from the bonds they hold. I am not sure why people are as worried as they are. I assume its the optics of the Treasury having to recapitalize the Fed or the Business Journalists writing stories about who the Fed is “broke”

  • http://www.pragcap.com Cullen Roche

    Agree Karl. It’s like worrying about the Tsy running out of money. Hmm, they have a printing press and they sure know how to operate it. :-)

  • Andrew P

    My concern is that if inflation starts accelerating, the Fed will just let it run. The economy is too weak for the Fed to tighten, so they have to let inflation run until the household sector is deleveraged from all its excessive mortgage debt. In the 1970s, the Fed let inflation run for the better part of a decade until Volker squashed it by raising rates. In the present environment, they would have to let it run for at least twice as long. Because gasoline is the most inflation sensitive necessity, and is globally supply constrained, the Government would have to ration gasoline to make the inflation politically palatable and to keep the Agriculture sector functioning.