More on QE/real interest rates as the New Cash Rate (Just Brainstorming)

Regardless of whether a taper begins this year or next, I'll continue to discuss my reasoning as to why the Fed's tapering will be equivalent to a rising OCR and a full exit should have roughly the same effect as an inverted yield curve for financial markets. There are several reasons for this, some of which may occur whether the Fed tapers or not - these I will discuss here.

Early in the recovery, when most people did not understand the potential effects of excess reserves and demand for bank credit, it was in vogue to panic about inflation, and inflation was fairly strong during QE1 and QE2. Whether asset purchases had a large direct effect on inflation or not when QE was running - while possible - probably doesn't matter too much. What matters now is that even if it was QE that was driving reflation in consumer prices, this effect is dwindling. The latest round of QE, despite being prolonged and open ended, has seen a gradual trend downwards in inflation (Source: St. Louis Fed):

While interesting in itself, when combined with the fact that long rates have unambiguously risen under balance sheet expansionary QE programs (despite the question of whether or not QE is the direct cause), this has lead to some notable effects; a rising real cash rate; positive real yields on long term US bonds. In effect, the Fed is not finding it easy to maintain inflation or financial repression, and the longer QE runs, the more attractive treasuries become relative to equities and other risk assets due to multiple expansion and falling yield spreads. (Source: St. Louis Fed):

Again - whether or not QE is inflationary - at the moment it is not stimulating strong inflation and the cash rate cannot go lower - hence real rates are rising. A negative real interest rate is associated with strong asset price performance, as it rewards various forms of speculative behaviour and leverage, of course, the opposite is also true of a sharp rise in the real rate.

The problem for a continued rally is that the real rate is becoming less negative, long yields more positive and yields on equity indices are lower than yields on risk free US long bonds (which is normal, but strong capital gains are not usually associated with valuations as high as right now). I know where I would allocate more of my money when the Fed has stopped expanding its balance sheet, but I am probably more cautious (not momentum chasing) and see a lot of relative value in treasuries vs equities as we head further into this dis-inflationary environment. (Source: St. Louis Fed):

If QE does end I am of the belief that inflation will move at least slightly lower (surely not higher), leading to real interest rates that are only marginally negative. Since the cash rate will not rise soon, positive real rates might only come about via deflation, something I'm not going to suggest is about to happen, but I suppose it is possible. Real rates moving less negative is a form of tightening in my opinion, given that this bull market has been a beneficiary of strongly negative real rates. Can marginally negative real rates sustain this rally? I really have my doubts that the repression effects are strong enough.

But, thinking more speculatively, if the Fed does not exit, eventually rising risk free yields must attract investors back, not to mention associated variables like rising mortgage rates will hobble the housing recovery, so there is a lifespan on QE leading to risk assets rallying over risk free counterparts. Perhaps the reason many people don't agree with this is that they believe that QE lowers interest rates on treasuries and raises equity valuations. If this was true, as I showed previously, yields and the index could not be positively correlated when QE is running - but they are, so it's a source of confusion for me that this is still the conventional wisdom.

What I am hinting at here, is that the narrative that the Fed will not allow risk asset prices to fall does not hold water. The Fed evidently has less control over inflation than it would like, and it's asset purchase programs have the effect of making risk free assets more attractive over time - thus a risk asset rally should be self limiting in theory. Every bull market has a narrative for why valuations are justified, and this gets overdone, leading to high valuations. Previously accurate forecasters such as GMO are estimating roughly a zero real annual return on US equities for the next 7 years, due to current high valuations

What is the catalyst for these valuations to begin to correct? For me, a tapering would be the start, but more importantly a Fed exit will see investors demand treasuries strongly in a portfolio. This is one point I'm fairly sure on - when the Fed exits completely, yields will plummet precipitously.

Name the Country

Here is a good test of your economic history, which country and what period am I describing?

1. Huge real estate bubble - perhaps one of the largest the world has ever seen, following on from a huge stock market bubble just a few years earlier.
2. Securitized residential mortgages and short term loans, packaged and on-sold to investors with the promise of high returns.
3. Widespread and systemic fraud to enrich business leaders.
4. A huge demographic shift about to take place as the workforce ages and shrinks.
5. Interest rates kept too low for too long, often negative in real terms rewarding speculative behaviour.
6. Rapidly rising debt levels, over 200% of GDP and rising at twice the rate of income growth.

If you said the US in 2005, you would be correct.


If you said China in 2013, you would also be correct.

Here is the problem: while many are watching the US and Europe and expecting them to fall apart at any moment, the real risk lies in the country that most are very complacent about. Developed Western country problems are known issues -  It is not typically the known economic problems that hurt investors, but the ones that consensus says do not exist.

This is hardly surprising given that risk management tends to go out the window in these cases and in periods of low volatility. Known issues often lead to intense scrutiny over exposure and possible outcomes, and this prevents them becoming more dramatic.

The US has done a lot to make it's economy more resilient following the great imbalances of its bubble years; bank recapitalization; de-leveraging; a shrinking trade deficit. Europe's banking system has not been fixed to the same extent, but the adjustment is at least under way despite some lingering structural issues. While these economies may face further hardship and recessions, their restructuring has begun. The opposite case occurred in China after the GFC. Instead of re-balancing it's economy, China doubled down on its investment growth story and fueled a credit and residential construction bubble.

China's credit fueled investment boom is not sustainable, yet there is still a lot of blind faith in a few bureaucrats to pull all these economic levers efficiently to create 7.5% real growth per year for the next decade. This is, despite all the historical precedents for investment growth models not re-balancing easily that Michael Pettis points out, and the precedent of state controlled economies being very poor resource allocators.

China will not fall apart immediately either. However, over the next few years Chinese growth will slow either voluntarily or involuntarily, and this has huge consequences for Australia. A lot of the China story probably won't be apparent until the tide goes out, and we see who is not wearing any shorts. Over the next year I will be aiming to describe Pettis' arguments for re-balancing from the perspective of Australia.

Playing Devils Advocate: I think most people have misunderstood QE's effect on yields.

One of the more common misunderstandings I come across is the idea that the Fed is keeping interest rates artificially low on government securities. This often manifests itself along the lines of:

“The Fed can’t stop QE or yields will shoot up and the government won’t be able to fund the deficit”

or…

“The Fed is funding the deficit. Who will buy the bonds when QE ends?”

and…

“Quantitative Easing increases the demand for bonds, and so yields fall”

People are more than happy to accept that QE drives up equity valuations as investors re-balance portfolios towards risky assets, yet struggle to make the connection that the flip side of this is lower speculative demand for long term bonds and that yields are determined by the market (as things stand currently), so expansionary policy must be reflected in yields. If the market does not price in expansionary policy, it is not functioning correctly, but it does and yields rise under QE. For this reason it is not easy to target yields and inflation simultaneously in free markets. In the current environment yield targeting takes a lower degree of importance to inflation and employment targeting.

This misunderstanding continues for many reasons:

1. A lot of confusion between real and nominal rates, and high yield vs. government debt yields.
2. Trying to fit data to theories rather than the other way around.
3. Because the truth, like many things in economics and finance, is actually very counter-intuitive and hard to accept without deeper thought.
4. Economists are not always traders, and there is some trouble understanding how market participants act.
5. The Fed is an easy target for venting frustrations.

I want to explain why this is misguided, because it leads to a lot of unnecessary fear regarding government funding, as well as poor decision making for unsophisticated investors. It is also leads to a trap where economists call for more QE to keep interest rates from rising, despite a strong possibility that QE is exactly what is making them rise in the first place.

Below I have highlighted the periods in which the Fed was making unsterilized purchases of longer dated Treasuries. If you showed this chart to a child, they would be able to tell you instantly that QE must raise yields, yet somehow many adults are seeing something different. I will discuss why they come to this erroneous conclusion, and why the reality is different to theory. Since I want to discuss the direct effects of long term bond purchases on those yields, I have removed Operation Twist (See discussion below) and purchases of MBS.

Analysis of Data:

Changes in the 10 year treasury yield since the onset of government bond purchases are as follows.

• Periods of balance sheet expansion:
  • QE1: +90 basis points
  • QE2: +51 basis points
  • QE3: +108 basis points
  • Cumulative effect on yields: +249 basis points or +2.49% on the 10 year.
• Periods of no balance sheet expansion:
  • Post-QE1: -82 basis points
  • Post-QE2: -156 basis points
  • Cumulative effect on yields: -238 basis points or -2.38% on the 10 year.

Notice that the 10 year yield is approximately back to its value at the start of the first treasury purchase program. All falls in yields have been associated with the Fed not expanding its balance sheet. All rises in yields have been associated with the Fed expanding its balance sheet. There is no evidence that balance sheet expansion (QE in its current form) reduces government bond yields in the US, and every indication that the opposite is true. If someone can work the data to say that yields have fallen under QE, they surely have their computer screens upside down.

The 10yr Yield and the SP500 is also becoming more positively correlated during each easing program (Yields and the index rise in tandem), with values of 0.55, 0.59 and 0.79 for QE 1, QE2 and QE3 respectively. This is what would be expected from a program that reduces speculative demand for risk free assets and increases speculative demand for riskier assets.

People should not expect to see significantly lower yields at the same time as the index moves higher – which highlights the point of this post: Many see the end of QE resulting in the stock market crashing at the same time as yields rising sharply, resulting in a government that can’t make ends meet. I don’t see the basis for this. The two variables are rising together, and will likely fall together when QE ends and deflationary threats become more pronounced.

Why QE doesn’t increase net demand for Treasuries:

At first glance, there doesn’t appear to be anything wrong with the quote at the top of the post, that QE increases the demand for bonds. To say the opposite – that QE lowers the demand for bonds – sounds insane, because obviously if the Fed purchases 45 Billion of bonds a month they must be increasing the demand for what they are buying. This is incorrect however.

For the Fed to buy 45 Billion per month, the private sector (mostly the household sector, including hedge funds) must be willing to sell 45 Billion per month. The simplest way to understand this counter-intuitive truth is to rephrase the statement:

“The private sector is selling 45 Billion worth of a bonds each month, this will increase supply and yields will rise.”

Because, for every buyer, there is an equivalent seller in each transaction - if the Fed wants to buy, someone must want to sell. It is possible that the percieved benefits of rebalancing towards equities might actually induce greater supply than the Fed's uptake, leading to rising yields. In the case of QE programs, the data shows that speculative sellers (largely households/hedge funds) are the parties selling to the Fed during QE. If QE induces a portfolio rebalancing effect, then it must also increase supply from these parties as they seek to move in to riskier assets.

“Recall, from the analysis above, households are the largest seller to the Federal Reserve for both Treasury securities and MBS. Now we find that purchases of Treasury securities by the Federal Reserve induce households to shift these asset holdings toward corporate bonds, commercial paper, municipal debt and loans, and bank deposits; MBS purchases drive all of the same substitutions, except for bank deposits. In addition, when pension funds sell MBS to the Federal Reserve, they thenshift their portfolio toward repurchase agreements, or very short-term assets. This evidence of shifting investors out of safe assets into riskier assets points to a credible channel for the effects of asset purchases on broader financial markets..." 

"... We find that not all investor types sell to the Fed uniformly. Households (the group that includes hedge funds), broker-dealers, and insurance companies appear to be the largest sellers of Treasury securities when the Federal Reserve buys these securities. Households, investment companies, and to a lesser extent, pension funds, are the largest sellers of MBS when the Federal Reserve buys." 

(Source: From Whom Does the Fed Buy?)

It should be clear from this understanding that the quantity purchased does not matter if the private sector sells willingly, and that prices will not be driven either way by this process alone. The Fed’s purchases do reduce the total outstanding supply in the market by moving the bonds on to the Fed’s balance sheet until maturity, relative to the counter-factual where the Fed made no purchases – this does not result in lower yields because QE simultaneously reduces new private sector demand for safe assets in favour of risky assets.

Taking this portfolio effect further, it also needs to be emphasized again that these are willing sellers. The Fed is not forcing these parties to relinquish their bonds, they sell because they see better opportunities elsewhere. There is no reason that the Fed's purchases would add to existing demand, because those that sold to the Fed will not reinvest their freshly issued deposit back into those same treasuries - because for them to do so would be a meaningless transaction. There is no incentive or reason for any investor to sell a bond to the Fed and then buy an equivalent bond with the proceeds.

It might be the case that sellers of long term treasuries may sell in order to purchase shorter duration bonds - this is probably occuring now as the Fed strengthens forward guidance regarding the Fed funds rate. Short rates are expected to stay at zero for longer, even if the Fed tapers its long term bond purchases, a message Bernanke is making sure to emphasize as tapering becomes more likely. This will put pressure on long term interest rates.

A simple diagram showing hypothetical effects – the reality is more likely that private sector demand falls by more (hence the rising yields) and Treasury keeps issuing new securities, however I just want to demonstrate how the portfolio effects of QE can net out to roughly zero and should not drive yields lower.

Furthermore, the Fed is a price taker in these transactions, not a price maker. That is, the Fed conducts a series of competitive auctions with its Primary Dealers (1). In this process, dealers submit offers to the Fed’s dealing desk and the Fed accepts the lowest priced offers received to fill it’s purchase amount (2). The Fed’s purchases in no way drive yields lower, because the Fed must accept voluntary offers from the private sector and the market comes to a price based on a number of other factors.

Why might QE raise yields?

With the exception of Operation Twist, QE has unambiguously been associated with rising yields and the end of QE programs have always resulted in this process reversing – leading to plummeting yields. The same occurred in Japan when Abenomics was supposed to drive long term rates lower, but instead yields on the 10 year JGB doubled under the program. Abe and Kuroda were surprised by this, but they should not have been after seeing the same effect played out many times before.

Firstly, when the Fed creates reserves ex nihilo, the market views this as expansionary and to some degree inflationary and prices this in to yields accordingly. Fed watchers over the last couple of years understand that banks don’t lend reserves (except to each other) and they are not reserve constrained. The aggregate of market participants however has a knee-jerk reaction to balance sheet expansion – that it is inflationary. From my understanding there is no direct effect on inflation, but through various second order effects such as exchange rate depreciation and lowering yields on risky credit instruments, there is probably some minor inflationary effects (though we can never know for sure without the counter-factual of no QE at all).

Because Operation Twist a) Was sterilized, and did not involve balance sheet expansion, and b) Targeted yields directly, it was not seen as particularly expansionary and inflationary by the market. Beyond this, traders will not fight the Fed if it wants to target yields. As quantitative easing is currently constructed, it targets a quantity of purchases but has no set yield target. This means firstly that the Fed does not have any control over yields, and that traders are not fighting the Fed by selling into the Fed’s purchases.

Secondly and more simply, markets ‘buy the rumour and sell the news’. This can mean pricing the event into the market in the lead up to announcement, or pricing it out of the market – dependent on what the market expects.

In the case of QE programs, the market front runs the Fed’s purchases by buying heavily before the programs begin, then ‘takes profit’ when the Fed enters the market, leading to selling pressure on treasuries and rising yields rather than falling yields. Purely academic economists sometimes struggle with this, but event driven traders will know that if an event such as tapering is to be announced, traders will continue to push yields higher until it is actually announced, then flood back into the market on the actual announcement, perhaps in anticipation of the next program – when they will again sell to the Fed. Rinse and repeat.

Finally, portfolios re-balance. QE makes treasuries unattractive and equities and high yield instruments more attractive. People are simply not willing to hold treasuries at the same low interest rates while QE is supporting risk assets, and they adjust their pricing accordingly.

QE can lower yields in at least 4 scenarios:

1. If the purchased quantity is too low to offset deflationary fears.
2. If the purchase program targets yields directly rather than a set quantity of assets.
3. If the program is sterilized and there is no central bank balance sheet expansion.
4. If yields are rising because there is sovereign default risk (Euro Area, sub-optimal currency area), QE can lower the risk premium by guaranteeing the solvency of the country.

However the Fed only has the ability to target one variable at a time. Richard Koo has explained this a few times, however I will go over it also:

1. If the Fed sets a firm inflation target, it loses control over what quantity of assets it must purchase to achieve this and cannot control yields (as the market will price in the inflation and yields rise).
2. If the Fed sets a monthly quantity to purchase, it controls it’s purchase amount, but can never really force a set inflation rate or maintain control over interest rates (hence the Fed hasn’t been able to achieve it’s target inflation rate or keep yields down).
3. If the Fed targets yields, then it cannot control the amount of assets it purchases to achieve and defend the yield and cannot control the rate of inflation. It might actually be the case that the market respects the Fed’s target yield, and so the Fed ends up buying very little from the market to defend its target – in this case inflation would be hard to come by. The opposite could be true in a central bank that has less credibility – the central bank might be forced to buy vast quantities of assets to control yields – in such a case the country might find itself in trouble.

Why make the claim that QE lowers treasury yields?

This is really hard to figure out, since it seems so clear from the evidence and the logic that QE hasn’t done anything to bring yields down. I have some suspicions.

1. Some economists set out to prove a point, then find data to support their perspective. I haven’t read every paper and article written on QE’s effects, but from the ones I have that claim a reduction of yields through QE I notice two ways in which the methodology seems disingenuous.
   1. By selecting arbitrary dates between which to run a regression instead of simply the period in which the program was actually running – this includes dates of announcements and discussions. If they regressed only the period between which the purchases took place I cannot imagine how they could come to the conclusion that yields moved lower under QE.
   2. By examining the whole period since the onset of the crisis. This ignores the deflationary effect of a bursting credit bubble (debt deflation) over the period in which yields kept moving lower, only to be periodically raised by QE programs. It also ignores the 30 year trend of yields moving lower due to a glut of savings and low inflation.
2. People confuse real rates with nominal rates. Some discussion argues that QE lowers the real interest rate by inducing inflation. This is obviously not the same thing as the nominal interest rate and I do not dispute that QE can lower the real interest rate. The problem is that this distinction is not made clear enough in much of the financial media, and so the point gets muddied and muddled until it is assumed that QE lowers nominal rates.
3. People confuse Treasury yields and the effect on high yield and corporate debt markets. QE has helped lower funding costs here, so QE does lower yields – just not for risk-free assets like treasuries. This is another point that gets confused and blended together, leading to incorrect conclusions.

Conclusions:

Though it can never be known for sure, there is a strong case to be made that the Fed is keeping rates artificially high, rather than low. Trying to picture the counter-factual – where the Fed did not begin its QE programs, it seems like a no-brainer that a debt deflation scenario, with an oversupply of savings would lead to some very low yields. Demand for credit would be incredibly low.

It is incorrect that the US Treasury will have difficulty funding itself when QE ends. I will need to explain this further in another post, but from a purely mechanical point of view QE neither lowers the nominal rate on bonds nor is it direct funding (as the Fed purchases in the secondary market). To the extent that QE may help to lower real yields, this may help reduce the significance of the debt over a longer term. From a short term perspective however, nominal yields will be lower without a QE program running so at best the effect is ambiguous as to whether it would be easier or harder for Treasury to fund.

For short term interest rates such as the Fed Funds rate, the Fed also is forced to keep rates higher than they otherwise would be (3) – this occurs because of the large quantity of excess reserves that accumulate due to banks inter-mediating purchases from the household sector. The Fed needs to pay interest on these reserves to maintain control over the Fed Funds rate, which, in the case of large excess reserve balances and no interest paid would see the Fed Funds fall to zero as banks sought to loan their excess reserves. By putting a floor under rates the Fed maintains control over its policy rate.

A Final Thought:

Explicit in my thinking here is that while QE is running, yields and the indices are positively correlated. This poses an interesting question – if QE makes risk free yields rise, and conversely makes yields on risky assets fall, will there come a point where the psychology behind QE ‘flips’ and stops working because the yield on risk free assets has risen enough that they become attractive again?

My belief is that, yes, this is the ultimate outcome if QE continues running indefinitely. The portfolio re-balancing of QE is largely psychological and not mechanical, and it can change if valuations get too far out of line or sentiment too bullish on equities and risk assets. At what point this would happen, I am not sure, but I think the idea that multiple expansion will continue regardless of anything else until QE ends is not correct (though it may continue for a while). When relative value differentials become large enough, Treasuries will look attractive and equities repulsive – especially considering the lack of inflation achieved by QE.

1. FOMC: Statement Regarding Purchases of Treasury Securities.

2. POMO FAQ.

3. Why pay Interest on Reserves?

Balance Sheet Fluctuations Have Replaced the Cash Rate

Following on from the previous note on Fed tapering and the new realities of monetary policy, I wanted to show graphically how correlations have changed and how this should affect asset prices moving forward.

I’m looking at EUR/USD here as the relationship is so clear, but equally revealing is a look at Federal Reserve assets against SP500 performance. Everyone already knows that Fed purchases have a direct relationship to equities performance, and I’ll talk about this in the next post. On the other hand, some people are confused that the Euro has not fallen to parity, so this is more interesting to talk about in the context of balance sheets and to show how rate policy has been replaced.

Prior to ZIRP there was little positive correlation between the balance sheets of the two central banks and the nominal exchange rate. More important were interest rate differentials, trade policy, relative economic performance and so on. Asset purchases were not the explicit form of monetary policy and so traders did not give such a heavy weighting to this balance. Of the previous determinants of exchange rates, interest rates have always been one of the most important, but more specifically expectations of policy easing vs. tightening.

Zero Interest Rate Policy was reached at the start of 2009, with the Fed Funds rate effectively zero. This means traders have needed to look to other forms of policy change for direction, and the most clear is asset purchases. The ECB’s policy rate has been in the region of 1.50-.25 percent since the onset of the crisis, it’s fluctuations were still able to have an effect on valuations, but not as strongly as the promise of balance sheet expansion (and in the case of the ECB – balance sheet reduction). Lets zoom in on the relationship since ZIRP was introduced:

This has made it very simple to understand where the respective currencies are heading. In the last month the ECB has taken steps to stamp out Euro appreciation by cutting rates to 0.25% and verbally discussing asset purchase programs. Leading up to this however the Fed has been vigorously outpacing ECB purchases with its 85 Billion-per-month program while European banks paid back LTRO loans (shrinking the ECB balance sheet). This has resulted in strong performance of the Euro, confusing Euro bears. The last rate cut goes some way to offsetting US easing, but until the ECB finds a way to adopt it’s own QE or further LTRO it will be plagued by a strong Euro while the Fed maintains QE.

The implications of this is that now that ZIRP has made rate policy defunct (and Central Banks are unlikely to raise rates), the market will be judging the banks’ easing bias by its expansion and contraction of balance sheets. The Fed is unlikely to contract it’s balance sheet, and statements have implied the securities will be held to maturity – therefore it is more likely that the end of expansion will be the equivalent of Fed tightening rather than an actual reduction in balance sheets. Traders don’t have another policy move to watch at the moment, and so focus is ever more focused on the timing and rate of a QE tapering.

As a side note however, there are also other reasons that Euro bears should not be bearish on the currency. If we ignore for the moment that German bureaucrats heavily resist most monetary easing (and so ECB policy has been much tighter than it could be), it should be understood that if the Euro is to collapse, this would probably be supportive of a stronger Euro.

Analyzing who has benefited the most from the Euro, Germany is the main benefactor – its trade policy keeping wage growth suppressed relative to productivity and the EUR being undervalued relative to a German national currency such as the Deutschmark has resulted in low unemployment and stable growth at the expense of peripheral European countries becoming heavily indebted. Germany is probably the least likely to leave the Euro because of it’s competitiveness benefits and the fact that it has a lot at stake in the project in loans to peripheral countries etc.

The peripheral countries however, while perhaps not a certainty to leave the Euro are surely more likely to than Germany. The PIIGS have been adjusting to this trade imbalance through rising unemployment and economic misery for now, but it can’t be ruled out that one or more of these countries comes to the conclusion that it will be less painful to regain competitiveness by leaving the Euro and devaluing a sovereign currency. If such a thing were to happen rather than the implementation of a fiscal union, the Euro should strengthen as the effect of weaker economies is removed from pricing in the Euro.

Moving House

Literally and figuratively. I'm moving to Melbourne in a month and moving the blog to Blogger. Wordpress was good, but the dashboard was prone to freezing and neither of my computers ran smoothly while trying to edit. Hopefully Blogger is less memory intensive and the computer can handle it. I am going to bring my recent posts over to save rewriting them.