When it comes to the ongoing (and increasingly shrill) debate about the effect of Fed balance sheet runoff on markets, a consensus seems to have emerged around at least one point. Namely that whatever the mechanical impact is, the psychological impact is greater.
This is something JPMorgan’s Marko Kolanovic neatly encapsulated in his most recent note (incidentally, if we had to guess, we’d say they’ll be something new from Marko next week). Here’s what he said on January 16:
Whatever the real mechanical impact is, likely the impact on market sentiment is much larger (i.e., self-fulfilling impact). In support of that are recent intraday movements on balance sheet mentions, as well as the price action of the S&P 500 during Q4 shown in Figure 8. While there may be little or no mechanical impact on equity prices, most macro traders are not ‘fighting the Fed’ – when liquidity is added they are buying assets, and when liquidity is removed they are selling assets.
That’s not to say there’s no mechanical impact. Obviously there is. When the Fed pulls the price insensitive bid at a time when Steve Mnuchin is increasing supply (to fund the tax cuts), the supply/demand dynamic for safe haven Treasurys changes materially and the onus falls on the market to absorb more net supply. That, in turn, saps demand for risky assets or, more simply, sucks liquidity out of the market.
The “problem” (if that’s how you want to couch things) is that there’s no generally accepted way to quantify the mechanical effect, although some folks (e.g., Morgan Stanley’s quants) have tried.
One thing we do know is that balance sheet runoff does exert a tightening impulse on top of Fed hikes, and that’s at the heart of the current debate about the inherent absurdity of tipping possible rate cuts (which the January Fed statement seemed to open the door to) and persisting with QT.
A couple of hours before the Fed’s “shock” dovish “capitulation”, we brought you some excerpts from a new SocGen note which finds the bank’s Solomon Tadesse reminding everyone why he suggested last May that the Fed would only be able to squeeze in a total of three more hikes. You can read more here, but the gist of it is this (from SocGen):
Accounting for the impacts of QE on what would have been the Fed rate absent the zero-bound, we argued in May 2018 that the course of the current tightening was much closer to its top by historical standards, projecting about three rounds of rate increases to reach the peak by December 2018. In fact, adding the current effective Fed rate of about 2.5% to the swift 300bp hike in the ‘shadow rate’ in the middle of 2014, reflecting the winding down of QE, the degree of tightening at present stands at about 5.5%, which is more elevated than the recent cycles (left figure). By contrast, rates went up only by about 4% in the post dotcom tightening cycle of 2000s. Relative to the much deeper easing needed following the 2008 financial crisis, however, the current tightening level is at the average peak level of the last few cycles (right figure).
Well, in a note dated Friday, Deutsche Bank takes up the same debate in a piece aptly entitled “Lurking in the shadow (rate)?”
Long story short, the bank attempts to quantify the rate hike equivalent of balance sheet runoff. As a reminder, this whole thing (i.e., balance sheet normalization) was supposed to be “like watching paint dry”, but thanks in no small part to a high profile WSJ Op-Ed, Donald Trump’s amplification of that Op-Ed in his infamous “50 Bs” tweet and the fact that when the Fed initially made plans to normalize the balance sheet, they weren’t figuring on the deluge of Treasury supply necessitated by US fiscal policy, this has become the hottest of hot topics. Here is Deutsche Bank reiterating that amplification and explaining why it’s likely to be particularly vexing for the Fed:
In recent months, the unwind of the Fed’s balance sheet has experienced a sea change from a process running in the background that was intended to be, to use Fed officials’ words, “as interesting as watching paint dry”, to the topic that is now at the core of most discussions about what is driving global financial markets. For Fed officials, this heightened scrutiny of the unwind has likely been a source of bewilderment. While they fully expected the drawdown in their balance sheet to have some hard-to-quantify tightening effect on financial conditions, the initial evidence of this transmission was expected to be through the yield curve, specifically via a higher term premium. If anything, curve dynamics have shifted in the opposite direction, with tighter financial conditions coinciding with a flatter curve as measures of the term premium remain stuck near record low levels. Thus, the market’s focus on the import of the balance sheet despite these curve developments is likely puzzling for Fed officials.
Right. But unfortunately, they (Fed officials) don’t have the luxury of being “puzzled” for too long, because while they’re “puzzling”, markets are panic-selling on any mention of the balance sheet that doesn’t include explicit references to a willingness to tweak the pace of runoff.
As ever, the issue is that we still don’t know how to precisely quantify the effect of QE on markets, let alone QT. For the sake of simplicity (and also to line up with the excerpted passages above from SocGen), we’ll skip to the section in Deutsche’s note that deals with the Wu-Xia shadow rate. The bank uses a straightforward linear model to map things. Here are the variables:
- the size of the SOMA portfolio,
- its weighted average maturity,
- the 6m3m OIS as a proxy for Fed expectations, and
- an index of FOMC forward guidance
Deutsche notes that they’re really only interested in the first two. The others “are used to control for other factors that may also have been drivers of the shadow rate during the regression period.” As it turns out, all the variables are significant. R-squared is 88%. Their conclusion is as follows:
Our model suggests that between 2008 and 2015, each $1 trillion expansion of the Fed’s SOMA portfolio helped lower the shadow fed funds rate by 62bp, while a 12-month extension in SOMA’s WAM reduced the shadow rate by another 29bp. Put another way (and generalizing the findings somewhat), the Fed had achieved the equivalent of a 25bp rate cut with every $400bn of asset purchases or with every 10 month of maturity extension for SOMA during QE and Operation Twist.
The implication is that if you just run this model in reverse, you can quantify the tightening impulse from balance sheet runoff. As shown in the right pane above, if runoff continues as projected in 2019, the total tightening impulse (in fed funds terms) from QT from October 2017 through the end of the year will be ~30bps or, a little more than one 25bps hike.
Deutsche uses two additional approaches which ultimately produce broadly similar results. They address, for instance, the supply/demand dynamics mentioned above from the perspective of the term premium. Here’s one particularly notable passage from that section:
So far, there is not a lot of evidence that the extra Treasury issuance that the public has to take down because of the SOMA portfolio runoff has had a large impact on yields. Compared to the end of September 2017, 10yr Treasury yields have risen by only a modest amount of 40bp. Remarkably, the term premium (the ACM measure), which has had a strong historical correlation with the volumes of Treasury issuance, has actually fallen by 40bp during this timeframe. In other words, the rise in Treasury yields since the runoff began has been driven by the increases in the fed funds rate and the market’s short-rate expectations.
The upshot of the bank’s piece is that no matter what model you use to try and quantify the fed funds equivalent of the total tightening impulse from balance sheet runoff, you’d be hard-pressed to come up with a justification for asserting that it amounts to more than one 25bps rate hike.
Of course, as noted here at the outset, that doesn’t address the elephant in the room, which is the psychological impact on spooked investors whose propensity to sell stocks whenever a Fed official suggests the pace of runoff isn’t subject to change can itself tighten financial conditions.