Capital Markets: "QT is not the Opposite of QE"

From Marc to Market:

The Federal Reserve has long been clear on the sequence of events as it innovated the playbook during the Great Financial Crisis. There would be a considerable period between when the Fed would finish its credit easing operations that involved purchasing Treasuries and mortgage-backed securities (MBS) and its first-rate hike. The normalization cycle would be well underway before the central bank would allow its balance sheet to shrink.

The early days of the recovery were weak, and a few rounds of asset purchases were deemed necessary before officials were convinced that deflationary forces were arrested and the economy had entered a self-sustaining recovery and expansion. In 2017, nine years after Lehman failed, the Fed announced plans to gradually reduce its balance sheet by not reinvesting the entire amount of maturing proceeds. The pace would quicken quarterly until reaching $50 bln a month in Q4 18.

I recall reading only one note that warned that through its balance sheet operations the Fed would tighten more than it realized and that was from Benn Steil and Benjamin Della Rocca over the Council on Foreign Relations (November 2017 here). While equities were cratering at the end of last year, many picked up Steil’s argument. I argued against Steil’s early warning at the time, and the subsequent iterations have not made it more compelling.

To be sure, the argument is seductive. When the Fed’s balance sheet was expanding, officials assured us, financial conditions were easing. The econometricians calculated that every $1 trillion of asset purchases was tantamount to 15-20 bp lower interest rates. As the process went into reverse, financial conditions should be expected to tighten, and rates rise.

Investors in risk-free assets were displaced by the Federal Reserve purchases and were forced to by riskier assets. As the Fed’s balance sheet shrank, high-risk assets would lose this bid.

The narrative is straight-forward and logical. There is one problem: the facts. With the Fed buying fewer Treasuries and the government issuing more, bond yields should have risen but instead, have fallen. The US 10-year yield peaked in November near 3.25% and today are below 2.70%. The impact on mortgage rates has also been counter-intuitive. Thirty-year mortgage rates are closer to 4.5% than the 5% rate seen in the middle of Q4 18.

What about equities? The S&P 500 reached a record high about a year after the Fed’s balance sheet began shrinking. The sell-off in Q4 18 was violent. Investors were looking for a culprit, and Steil’s balance sheet argument was ready-made and helped by a tweet from President Trump that also referred to the reduction of the balance sheet.

Equities have come roaring back, not just in the US but also the riskier emerging market equities. The Federal Reserve’s rhetoric has changed, and it may raise rates less this year less than the two times signaled in December. However, the balance sheet continues to shrink, though operationally the pace is closer to $40 bln a month than $50 bln.

If we are to conclude that Quantitative Tightening (QT) is not really tightening financial conditions, what are we to make of Quantitative Easing (QE)? The econometricians want to measure quantities of both flows and stocks, but price changes do not align....

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