Like watching paint dry, or Candidate No. 1 for the next global financial crisis ? That's the thing about reversing QE ..... it's never been done before.

Thursday 21st September 2017

ref  :-  "Yellen pulls trigger to reverse QE but we're now in uncharted waters" , Ambrose Evans-Pritchard in the Daily Telegraph

No surprises from the Fed yesterday per se, though the subsequent lift in US Treasury yields and in the Dollar attested to the Fed's accompanying script being more hawkish than some expected. A majority of the Fed's Open Market Committee are still pretty gung-ho for a rate rise in December (now a 96% probability, according to some measures) and for another three hikes in 2018, though the median projection for longer-term rates was adjusted down from 3.0% to 2.75%.

Fed Chair Janet Yellen also confirmed to no one's great surprise that the task of shrinking the Fed's balance sheet, bloated by the accumulation of bonds purchased through the Quantitative Easing (QE) process, will begin next month. Before the financial crisis, the balance sheet was running at roughly $800 million  --  it now stands at close to $4.5 trillion, almost all of it the portfolio of Treasury bonds and Mortgage-backed securities bought to suppress yields. With the economy trucking along at a respectable lick, the Fed has decided that it's time to reverse the process, a move which inevitably is being termed Quantitative Tightening (QT).

There has never been any chance of the Fed actively selling its holdings onto the market  --  such an aggressive move and the dramatic upward spike it would cause in rates and yields would come as a calamitous shock to global markets up to their eyeballs in debt. Rather, because so much of the Fed's holdings matures over the course of the next five years it will be able just to let the bonds mature and NOT reinvest the returned capital, as it has been doing up to this point. To begin with, the Fed will allow $10 billion of securities to run off per month without being reinvested ($6 billion US Treasuries, $4 billion Mortgage-backed securities), and will gradually increase the amount to a total of £30 billion per month. When the balance sheet has been shrunk to $3 trillion, it will reassess the situation (it's never likely to go back to pre-crisis proportions).

So it will be a long, gentle process, well-signposted in advance and the logical step for an economy years into its growth cycle  --  a step that should be easily absorbed by a well-prepared market . At least that's the assumption ..... and the origin of Philadelphia Fed President Harker's much-quoted remark that QT (as we can now call it, though he didn't) will be the "policy equivalent of watching paint dry".

Others, it's fair to say, are not so sure.....  Deutsche Bank for example, who have called it the start of the "Great Central Bank Unwind". They're probably right in that the ECB will ultimately have to go down the same route, though since the debate in the Eurozone is still about reducing the level of stimulus rather than actually tightening, they've still got a way to go. ***

*** It's an interesting question : if you, as a central banker, reduce the size of your QE purchases from  €60bn a month to €30 a month say, are you in fact tightening ? Or are you still adding stimulus but just in smaller size ? Theoretically the latter perhaps, but in practice the market will see it as a tightening. ***

But we digress ..... the Bank of Japan also has a huge balance sheet to consider as a result of its QE programme, and though it has expressed no interest in reversing the process yet it may be forced to for reasons of its own  --  not least that there's not much left to buy. The BoJ already owns 75% of the Tokyo ETF market, for example. In total, central banks have accumulated $14.4 trillion through QE, which has done some very strange things to asset valuations on the way up and it's reasonable to assume could cause chaos on the way down. Perhaps that's why Deutsche see the reversal of global QE programmes as candidate "Number One" for the next financial crisis.

That's a pretty dark way of looking at things but there's an undeniable logic supporting those who suscribe to the view that if QE has been so successful in promoting growth by lowering borrowing costs and compressing yield spreads, then surely it's sensible to expect the opposite results from QT. As Torsten Slok of Deutsche puts it : "Either QE policies have an impact or they don't. You cannot have it both ways".

Ben Bernanke, ex-Chairman of the Fed and one of the chief architects of QE, has warned his successors to leave the balance sheet well alone and let the economy "grow into it" over time. That's poison to the monetary vigilantes on the political right keen to influence the Fed, but his point is that we've never been here before and it's simply too dangerous to reverse QE if it's not absolutely necessary ..... which, he argues, it isn't. Besides, many believe that the Fed has more pressing issues.

There is certainly an argument for raising interest rates to minimum safety levels before you even begin to look at the size of the balance sheet. The Fed simply has no buffer against shocks with rates at or near current levels. History suggests that rate cuts of 300 - 500 basis points are typically required to fight recessions, and "during the Lehman crisis the Fed ran out of ammo after 475 basis points  --  which is why it resorted to QE. The "synthetic" total was 850 points of loosening". Currently, the Fed has 100 basis points to play with.

The changing, politically-influenced make up of the Fed means that a return to QE (should it be considered necessary) would not be an option anytime soon anyway, so the argument goes that it would be much wiser for the Fed to goose rates higher before they even think about tackling the balance sheet, notwithstanding stubbornly low inflation data.

As we've said, the Fed's position is that its "softly, softly" approach means it is well within the markets' ability to absorb the very gradual trimming of the balance sheet without stress. It's not so much that people believe the Fed to be wrong that's made them so twitchy, it's more the contemplation of how dire the consequences might be if that scenario should come to pass. The vertiginous asset price inflation in stocks and bonds brought on by impossibly easy monetary policy mean that markets would be vulnerable to massive corrections if they failed to absorb QT in the relaxed manner that the Fed envisages. Much of those asset purchases (and much else) have been funded by debt of course, and it's a sobering thought that the world's debt-to-GDP ratio was 276% just before the Lehman crisis and it now stands at 327%  --  not at all a comfortable statistic if you're contemplating a sharp spike in yields.

Let's just hope the Fed is right ..... otherwise they (and other central banks) could face a huge problem with effectively no tools at their disposal.