If you were watching every tick during Jerome Powell’s press conference on Wednesday, you’d be forgiven for thinking that market participants are at least as concerned about the Fed’s steadfast refusal to countenance tweaks to the balance sheet runoff plan as they are about rate hikes.
A simple look at the S&P as Powell spoke shows the selling accelerated when the balance sheet came up and to be clear, part of that is likely due to the fact that Trump brought the issue to the public’s attention prior to the Fed meeting, thus heightening concerns.
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That said, Trump is late to this party. People whose brains are much “larger” than Trump’s and whose “guts” actually are reasonably reliable, have variously warned that the Fed should calibrate the pace of balance sheet runoff to take account of the “tremendous” (to use a Trump-ism) uptick in Treasury supply necessitated by the President’s fiscal policies.
This isn’t complicated. The greater the burden placed on the market in terms of absorbing a larger net supply of U.S. debt, the less liquidity available for risky assets. It’s a “crowding out” effect and when considered in conjunction with rising rates on USD “cash”, the read-through for other assets is profound.
Well, in a note dated Friday, Goldman writes that while “Fed balance sheet runoff may indeed have contributed to some extent to the recent decline in risk appetite”, they are reluctant to “assign to it a central role in explaining the bearish market trends in 2018H2.”
The real culprits, the bank says, are decelerating global growth and the above-mentioned allure of rising rates on short-term USD debt or, more to the point, the appeal of “cash” as an investable asset.
To support this relatively benign take on balance sheet runoff, Goldman simply cites price action in MBS and Treasurys.
“If Federal Reserve balance sheet normalization was the major driver of the 2018 bear market, we would logically expect to see agency mortgage backed securities and Treasury bonds experience out-sized price declines, as these are the assets most directly affected by the runoff”, the bank writes, before explaining that “agency MBS excess returns under-performed vs. IG corporate bonds on the year, but only to a modest extent, and agency MBS excess returns in 2018 have been roughly in line with their usual relationship to equity returns.”
(Goldman)
On Treasurys, Goldman flags the bleeding term premium and an inverted real yield curve. “If Treasury bonds were cheapening because of runoff of the bonds from the Fed’s portfolio, we would expect widening in the term premium component of Treasury yields, as occurred in 2013 during the taper tantrum episode”, the bank says, before reiterating the obvious, which is that the term premium remains suppressed.
Finally, Goldman leans on what one might fairly describe as a “common sense” approach to this issue, noting that “the magnitude of the Fed’s balance sheet runoff – $330bn in face value to date between mortgages and Treasuries – does not seem large enough to explain recent asset price movements, given that the NYSE alone has lost $3.3tn in market value in recent months.”
Duly noted. And that speaks to the contention that there are other factors at play which help to explain equity volatility and a lack of liquidity. Top-down liquidity concerns (emanating from a withdrawal of central bank accommodation) are exacerbated by bottom-up issues (as manifested in low bid/ask depth and diminished top-of-book depth). Additionally, increasingly erratic domestic and foreign policy emanating from the Oval Office makes things immeasurably worse for risk assets, and contributes to the “sell the rips” mentality that supplanted “buy the dip” in 2018.
Still, it’s certainly no coincidence that “buy-the-dip” stopped working just as QE morphed into QT, an epochal shift that’s now colliding with the ongoing decline in the Chinese credit impulse.
(Bloomberg)
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My, admittedly non-expert, understanding of QE and QT is that, by buying treasuries in QE, the Fed drives up the price which lowers the yield. Presumably the reverse happens with QT – treasuries mature; the government needs to roll over its debt; the Fed doesn’t buy more, so demand is reduced; and the prices go down and yields up.
What this means to me is that the first order effect of QT is on the yield curve, which, as noted above, seems not to have noticed QT. I’d like to better understand the other effects, such as the effect on liquidity, which is often mentioned, but which I’m having a hard time getting my head around.
John you are exactly correct. But as H points out in isolation that works but there are other factors. Deficits/new supply, inflation and economic trends (demand for capital), flows, other asset valuations (stocks at 100 times earnings QT would be less of an issue stock at 3 times QT would drive up rates) etc.
Liquidity is how easy it is to trade and not move the price. So if i trade $100 and the price moves $5 (up or down depending if i am buying or selling) liquidity is poor.
If I trade $1Bn of a stock and it moves by $0.05 (up or down depending if I am buying or selling) then liquidity is great.
Right now if someone wants to sell there are few buyers around the current price so it has to go lower to find the volumes to transact. Sellers are aggressive and buyers cautious and lower.
QE was done to encourage risk taking, increasing capital available, and lower the cost of capital. It did drive up asset prices and provided some benefit but I contend less than expected. Real tax reform, smart regulation/deregulation, education, etc are much better drivers of prosperity.
Hope that helps.
Those are better drivers of prosperity and the key, productivity growth. But, this collection of Republicans can’t deliver any of that.
All you need is powerful enough blow torch to melt the “Steel Slats”. the five billion barrier can go up in smoke.
H
How much of the selloff can be laid at the feet of the stable genius in the White House and his band of merry disrupters? I figure it at 60 percent headed to 70.
My take on the past ten years is that the FED used its options to stem the downturn in 2008 and with QE in 2011 to ensure a coutinuing recovery. The result of these strategies was to grow the money supply sigficantly in excess of our country’s need as shown in GDP growth. The excess money supply growth needed to find a home which it did in financial assets: stocks, bonds,commodities and real estate. The result of the excess money supply was an increase in the broad stock averages of 400%+, recovery of real estate prices, stabilization of commodity prices. My expectation is a give back of some of the gains as the FED reverses its course should be expected.