There can’t be many market participants, other than those with the memory of a goldfish, who will have forgotten the shock and awe which the Federal Open Market Committee created at the point of the release of the minutes on April 5 of its March 14-15 meeting.
The minuted discussion regarding the need to begin to reduce the size of the central bank’s bloated balance sheet had otherwise sane investors running for cover screaming. I was myself, as some more regular readers might recall, slightly more sanguine and I suggested right out of the blocks that by the time of the release on May 24 of the minutes of the May 2-3 FOMC convocation, the temperature would have been toned down quite sharply. And so it proved to be.
It is quite extraordinary to find how many market participants still have not grasped that when the Fed lets a bond mature without reinvesting, that the debt has not gone away. One lender will have left the stage but not the borrower. Any cent which the Fed does not lend has to be lent by somebody else and with around US$3.4trn of securities held in portfolio under the quantitative easing programme, there are plenty of other lenders to be found to replace the Fed. This is an issue that the members of the FOMC have picked up although most of the press and media reports I have come across so far don’t seem to focus on this important issue.
GRADUAL
Thus we read in the minutes: “Policymakers noted that pre-announcing a schedule of gradually increasing caps to limit the amounts of securities that could run off in any given month was consistent with the Committee’s intention to reduce the Federal Reserve’s securities holdings in a gradual and predictable manner as stated in the Committee’s Policy Normalisation Principles and Plans. Limiting the magnitude of the monthly reductions in the Federal Reserve’s securities holdings on an ongoing basis could help mitigate the risk of adverse effects on market functioning or outsized effects on interest rates.”
Note the words “…mitigate the risk of adverse effects on market functioning or outsized effects on interest rates”. Here the FOMC shows extreme maturity in that it very clearly recognises the systemic risks involved in the hunt for new investment dollars. The gaping differential between long-term interest rates and dividend yields remains one of the biggest, if not the biggest hurdle to a normalisation the Fed’s balance sheet.
From a commercial investor’s point of view, putting the Fed’s holdings up for sale – and that is what letting the balance sheet run off is, whether you like it or not – is tantamount to an increase in the Treasury’s net borrowing requirement and hence in supply. But who, in light of that, will go banging at the Treasury’s door in order to beg to buy extra bonds at the still artificially low 2.25% yield when the purpose is to let some of the air out of the overinflated yield curve? That would be like the turkeys voting for Christmas.
The FOMC is clearly cognisant of the fact that it has created an artificial and inflated treasury bond market and that its attempts to gradually withdraw is fraught with a catalogue of potentially dangerous and surely unintended consequences. The argument that an equally inflated equity market – the S&P hit another record all-time high of 2,404.49 points in Wednesday’s trading - is supported by the uncompetitive returns on bonds, especially when low coupons are not augmented by capital gains to offer acceptable total returns, remains rock solid but what happens to stock prices if, as and when they do? I know I don’t have the answer to that one but I do know that we are still a goodly way away from that event occurring.
The Fed talks of limiting the amount of bonds it can let mature on a monthly basis without reinvesting the funds. In the minutes, that limit is referred to as a cap. Though not mentioned, the market seems to have pinned that figure for that cap at US$8bn per month for Treasury bonds and at US$4bn per month for MBS paper.
The very last lines of the minutes read: “Policymakers agreed to continue in June their discussion of plans for a change to the Committee’s reinvestment policy”. So the gun has been cleaned but so far not been loaded and it is most certainly not cocked. The FOMC seems quite clear in its appreciation that it is holding a tiger by the tail, something I sense the markets have not fully grasped.
If the Fed really were only to reduce its holding by a gross US$12bn per month, then it would take around 25 years for it to return its balance sheet to pre-crisis footings. On one hand we have an FOMC that is making up policy as it goes along – it is the one that told us that it will make decisions based on its interpretation of current data – and on the other it is talking about a balance sheet reduction programme, which could take a quarter of a century to execute. As I wrote quite clearly after the publication of the last minutes on April 5, I’m not sure we’ll see much of a reduction in the balance sheet within our working lifetime and if President Trump gets his way on infrastructure spending it’s more likely to go the other way.
VIENNESE WALTZ
Meanwhile, the OPEC grandees plus the Russians are back at work in Vienna where the production caps are expected to be extended through to the end of Q1 2018. Suspicion has to be that there is something going on that we, in central bank terms, refer to as “verbal tightening” where talking a good story is as important as actually doing something. The US shale gas conundrum has not been resolved. On the contrary; the low price of energy that has stalked the market for the best part of three years has not forced the high-cost shale producers out of business but has driven technological advancement and more cost efficient production. In other words, US$100 per barrel or even US$75/bbl seems further away now than they were just 12-18 months ago.
The weakness of the US dollar that continues on a daily basis should not be underestimated. On January 3 WTI closed at US$52.33/bbl when the dollar was at 103.21 on the index. As at last night the black stuff cost US$51.36 but the value of the greenback had dropped 6% to around 97.017. That amounts to an over 5% decline in the true value of oil in just under six months. Are you surprised that the OPEC boys are scrambling for something, anything? The oil companies’ liabilities may more or less all be in dollars but governments’ aren’t. Oops….
Markets don’t feel any too uncomfortable as investors of all ilks continue to reach for yield. Rewards for risk may be paltry but in most people’s books they are still a hell of a lot better than the rewards for no risk. Stay long.
Finally, in as much or as little as I am a fan of association football, as a native Mancunian I have always stood behind the sky blues of City. Nevertheless, and in the context of recent events at home I’d like to congratulate the boys of United on winning the Europa League last night. There is nothing better they could have done for the battered town and for its people. Thank you.