Eight years of monetary stimulus is coming to an end in the United States.
In the aftermath of the 2007-2009 financial crisis that plunged the global economy into a depression not seen since the infamous 1929 crash, the Federal Reserve purchased over $3.5trn of toxic securities, which took their total assets from 7% to 25% of GDP.
This ‘quantitative easing’ programme of asset purchases, supported by record low interest rates, has divided opinion. One achievement has been to reduce volatility levels on the bond and equity markets to the lowest level in decades.
The 10-year US Treasury Vix Index, a measure of 30-day forward implied volatility, has fallen to 4.6% versus 14.6% in the height of the crisis. On the other hand, Treasury yields have been suppressed to record lows, with the 10-year currently at 2.17% at the time of writing, and this rate has even remained unfazed by the threat of rising interest rates and other inflationary pressures.
Many professionals have begun to question these asset price valuations; Paul Singer who is the boss of Elliott Management Corporation Fund, which has over $28bn worth of assets under management, labelled the yield conundrum as ‘the biggest bond bubble in world history’.
Indeed, as of August 2016 over $13,000bn of bonds were trading in negative territory, meaning that investors were paying for the risk of holding the debt, not the issuing entity. With loan interest rates, mortgage rates, as well as many other instruments tied to this market, a bursting of this bubble, could spell catastrophe for households and investors alike.
This is precisely the problem on the minds of the Federal Open Market Committee, who reconvene for their monthly meeting on the 13th-14th June. At this meeting, the board are likely to announce a 25bps interest rate hike, in addition to further disclosing their strategy for unwinding the balance sheet without causing an economic shock.
Looking at the Past
History tells us that this is not a first-time situation for the Central Bank, nor would it be the first chance that they have created market panic by their method of dealing with it.
In the aftermath of World War Two, the total assets on the Federal Reserve balance sheet hit 23% of nominal GDP. Instead of actively reducing the balance sheet immediately, the Central Bank allowed the percentage to be reduced over time through growing GDP which eventually brought the amount down to a long-term average of around 5%, over a period of 30 years.
This, in the long run, had no influence on the markets. However, there are two problems with attempting this approach again. Firstly, economic growth in the thirty years succeeding World War Two averaged 3.8% – almost three times the average growth rate since 2009. Secondly, the independence of the Central Bank itself could be at stake.
Policy in Disguise
Kevin Warsh, a former Fed governor, referred to the Central Bank’s asset purchase programme as ‘fiscal policy in disguise’. The concern is that future governments will attempt to utilise Fed balance sheet expansion as an opportunity to fund fiscal spending without raising taxes.
Problems concerning liquidity on the bond market are likely to re-emerge, with major market participants already changing positions at the forefront of the market.
Throughout 2016, the Chinese government sold $200bn worth of US treasuries to support the renminbi, a total reduction of 17% of their Treasury holdings. Japan have also become net sellers of Treasuries in recent years, and in December made their biggest fire sale of US bonds in four years.
The overall percentage of US Treasuries held by foreign institutions has reduced to 43% from 56%. Such offloading from foreign institutions will result in pension funds once again being the dominant market participant, along with retail investors.
As these funds are more sensitive to price variations, their transaction activity will be far more frequent, which in turn will bring us back to an era of higher and more common upticks in volatility. Changes in market structure driven by regulation and technology has also reduced liquidity.
On the topic of asset price valuations, the entire QE programme reduced the 10-year premium by 120 bps in 2013, increased equity prices by approximately 15% and reduced the dollar value by 5%. Overall, helping to reduce total unemployment by 1.25%.
If the wrong signals are sent then a sizable market correction could occur, the likes of which were foreshadowed by the ‘taper tantrum’ case in 2013, when the then chairman Ben Bernanke announced that the Central Bank would gradually wind down its bond purchasing programme, resulting in an exodus of asset prices and currency values.
Shrinking the Balance Sheet
At present, the Federal Reserve is holding a total of $1.8trn worth of mortgage-backed securities, accounting for 33% of total outstanding MBS’s on the market, as well as $$2.5trn of Treasuries, 18% of total outstanding on the market.
To shrink this balance sheet, the Fed can simply stop reinvesting the principal when the bonds expire. This would result in an immediate decrease of $280bn from now until the end of the year, amounting to $680bn by the end of 2018; $224bn of which are mortgage-backed securities.
The FOMC have already announced an intention of employing a ‘cap’ which will moderate reinvestment, allowing the balance sheet to be gradually reduced without causing a shock to the markets. In addition, there will be no net selling.
Analysts initially predicted a $20bn per month reduction, although these estimates have since been reduced to an initial figure of $10-$15bn. Barring disaster, this entire process will take between 5-10 years.
Finally, how large should the Fed’s balance sheet be? In the past ten years, total cash in circulation has risen to $1.5trn. This immediately introduces a lower bound, for currency is a key component of total liabilities for the Central Bank.
An extra $1trn will be required to sustain this position according to Fed staff, meaning that already the balance sheet will stand at $2.5trn, $1.7trn higher than before the financial crisis.
In a New York Fed survey conducted in April, the average responder anticipated that the Fed’s balance sheet would hold $3.1trn by 2025, 22% of which will account for excess reserves.
Last Thursday, Fed Governor Jerome Powell stated that ‘It’s hard to see the balance sheet getting below a range of $2.5-$3trn’. Former Fed chair Ben Bernanke also announced that ‘In a sense, the US economy is “growing into” the Fed’s $4.5trn balance sheet, reducing the need for rapid shrinkage over the next few years’.
Investors around the world have long called into question the eight-year bull run of the US capital markets. An unwinding of the Fed’s balance sheet, if done incorrectly, could spell a major correction which could see largest losses of capital since the crisis.
The sensible move would be to reduce assets at a rate proportional to forward analysis of economic growth while maintaining interest rates at 1.5% ceiling rate. Thus allowing the balance sheet to be unwound without the market feeling the pinch.