‘The Fed Will Likely Monetize The Entire Stimulus Delivered By Congress’ (And Making The Covert, Overt)

Given massive deficit spending to fund multi-trillion dollar stimulus, you might be inclined to suggest that, eventually, the curve will bear steepen aggressively as the expected supply deluge outweighs offsetting Fed purchases.

This is the “crossover” argument, and Deutsche Bank’s Stuart Sparks breaks it down in a new note.

A simple chart illustrates the point. As Sparks writes, “coupon supply net of Fed purchases is likely to turn positive during Q3, even if the Fed monetizes the entire fiscal stimulus package as it currently stands”.

(Deutsche Bank)

Remember: Creating a net negative supply of safe-haven bonds is part and parcel of how QE functions. Initially, it forces investors to extend duration, which pushes down the term premium. After that (i.e., once simply taking on more duration risk is insufficient to generate returns), you have to move out the risk curve and down the quality ladder.

In that fashion, QE creates demand for corporate issuance and herds capital into corners of the market which might have lost access otherwise.

Also, recall that there are two channels through which QE functions. There’s the “stock effect” (i.e., risk-free assets are sequestered away on central bank balance sheets) and the “flow effect” (i.e., the incremental, marginal bid from ongoing monthly purchases). Smart people can (and have) debated which is more important.

Deutsche’s Sparks notes that the “crossover point” argument mentioned above is effectively the QE “flow effect” in reverse. That is, increasing Treasury supply against decreasing Fed purchases should push yields higher, just as increasing monthly Fed buying against static or decreasing issuance would push yields lower.

But there’s a problem – that thinking is too simplistic, especially in the current environment.

“It ignores the flows between the present and the time at which this crossover occurs”, Sparks writes, before clarifying:

That is, large purchase volumes at higher than market WAM should flatten the term premium and push yields lower until the crossover point. Yields might rise and the term premium steepen, but from lower and flatter levels.

So, you have to take into account the effects of Fed purchases between now and the point at which supply starts to outstrip the monthly Fed bid (i.e., you need to factor in the next few months’ worth of Fed buying and its likely effect on yields and the term premium when you make projections). Sparks continues as follows:

Pragmatically, one would expect the effects of large asset purchases to be cumulative, and to occur at a lag. For this reason QE is something of a hybrid between stock and flow. Intuitively, Fed purchases of, say, $100 billion/month should have a different impact on the market if they were preceded by a period in which the Fed bought $2 trillion in total than they would had the Fed bought nothing previously.

In order to accommodate that, the bank’s own term premium model employs what Sparks calls “a hybrid proxy for global QE flows”. The variable is the expected value of 3-month cumulative purchases, in three months.

If you’re wondering what this means in terms of the interplay between the virus stimulus bills (three in total so far) and Fed purchases, Deutsche Bank says that on their projections, the Fed “will have fully monetized the first three phases of fiscal stimulus totaling around $2.2 trillion”.

Not only that, the bank expects Jerome Powell to eventually accommodate the “phase four” recovery bill which, if Donald Trump has his way, will be upwards of $2 trillion.

Now, you might argue that by the time the “crossover point” is reached, the virus will have peaked and the economy will be on its way to recovery. Why does that matter? Well, because if the recovery is “V-shaped”, it could mean the Fed slams the brakes on accommodation, leaving only the massive supply of new issuance.

“This argument is perhaps the most consistent with Treasury cheapening as it could be consistent with a rapid taper of QE purchases in the relatively near term”, Sparks says, before noting that in Deutsche’s view, “the probability of this scenario is low”.

Rather, the more likely scenario is that although the Fed will continue to taper its purchases, it will remain in the market with a large enough bid to keep downward pressure on real yields and the term premium.

That is, of course, intuitive. Just about the last thing that can be allowed to happen over the next six or so months is for real yields to surge and the term premium to rise, as the former could lead to an encore of March’s extremely pernicious dollar appreciation and the latter would incentivize investors to move away from risk assets.

With rates now at zero, the Fed will need to ease using the balance sheet – i.e., the Fed will need to keep expanding its holdings, which crossed $6 trillion last week. Consider this bit from Sparks on real yields and the dollar:

High real yields keep the dollar strong, which keeps downward pressure on commodity prices and hence headline inflation. Note that the spike in real yields as BEI declined coincided with, and in our view drove, the sharp dollar appreciation during March. Moreover, we think it is important that the broad dollar is stronger than before the Fed began to ease, and remains higher than end-2019 levels in spite of the fact that 10y real yields have fallen 50 bp. The implication is that real yields likely need to fall further to stabilize the dollar and improve the prospects for persistent increases in headline and core inflation.

As noted in these pages on countless occasions over the past five weeks, the world is a friendlier place when the dollar is on the back foot, and last month’s “vertical” spike in the greenback caused all manner of problems across assets.

As Sparks notes, in addition to exacerbating risk-off behavior and perpetuating a kind of self-feeding loop that includes widening basis swaps and fire sales to raise USD funding, rapid greenback appreciation exacerbates the deflationary impetus from the coronavirus demand shock and plunging crude prices.

So, again, Deutsche expects that tapering notwithstanding, Fed buying will “remain sufficiently large to exert further downward pressure on the level of real yields and the term premium” for the very simple reason that tolerating a rise in either “runs contrary to their policy goals”.

In case it isn’t clear enough by now, anything that runs contrary to policy goals isn’t tenable.

After all, Sparks writes, “these are administered markets”.

Happily, pursuit of these policy goals will lead to the Fed monetizing the entirety of the stimulus bills coming down from Capitol Hill, including the fourth bill which hasn’t even been written yet.

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A brief epilogue

Some among you may have found yourselves wondering over the past month whether this entire process is overly complex.

If the Fed never actually unwinds its balance sheet, then QE was always just arm’s-length deficit financing.

This has, of course, been readily apparent for the better part of a decade, and if we’re all being honest, the post-crisis experience has proven that the middleman is, at best, unnecessary, and at worst, a hoarder of funds as opposed to a benevolent transmitter of monetary policy to Main Street.

Here’s Stephanie Kelton to explain:

We have Covert Monetary Financing (CMF) now. Primary dealers take up Treasuries, and the Fed backstops primary dealers. Ergo, the Fed is *already* directly coordinating with fiscal all day, every day. 

Circumventing primary dealers by having the central bank purchase bonds *directly* from Treasury robs PDs of some profiteering but otherwise changes nothing. Just makes it all more transparent so that the covert becomes overt.

So anyone who says we are “moving toward MMT” or whatever is missing the point entirely. MMT has always been about describing the institutional framework and the monetary operations *as they currently exist.*

Yes, we can move away from our current (opaque) system to a more transparent one, and we have offered many ways to do that (including OMF). The point is that it has been MMT all along, because MMT has been describing how the actual (monetary) system works.

If you’re wondering whether this can be taken one step further in the interest of simplifying it completely, the answer is “of course it can”.

“A monetary sovereign does not need to tax or borrow in order to spend and any interest paid on bonds it chooses to offer is a policy variable”, Kelton wrote Friday morning.

Think on that.

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