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Monday, 11 December 2017

On Q-End D-Day

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  • Peters 475px June 2014

Overheard at Anthony Peters’ cracking dinner: “We’re in a bear market; it’s just that nobody knows it yet”.

At last it is October 29th.

For more or less a year we have tacitly had this date pegged as the one on which the Federal Reserve’s Quantitative Easing programme was to meet its maker. The discussion as to what it has, or has not, achieved is still in full swing and it will surely do so for the next 20 or 30 years. It will most probably not cease until someone has written a PhD thesis on what effect QE had on the nutrition of rural communities in Idaho.

The debate is of course as fatuous as those musing on what would have happened if Napoleon had won at Waterloo (in which case it would surely have been the Battle of Belle Alliance), Robert E Lee had triumphed at Gettysburg or von Manstein had broken the ring around Stalingrad and had relieved Paulus. I’m happy to play the game but I doubt it will add anything of value.

Of far more interest will be to try to assess what happens next. My favoured toy, the US Debt Clock, reminds that the US national debt now stands at US$17.9trn which is fine and dandy when it comes to the knowledge that it will never be repaid but less so when one wonders what happens to government finances if, as and when the refinancing costs begin to rise.

With no statistical evidence to back it up – I make my daily bread broking bonds and not poring over econometric models – I would guess that the net cost of financing the debt pile has been pretty stable in the past seven or eight years as interest rates have been falling about as fast as the debt has been rising.

The ratchet will tighten slowly

It is, truth be told, not all that difficult to argue that the entire economic recovery in the US and in the UK too, for that matter, has been built on a bubble of QE and that it is unlikely that it will survive long beyond the retrenchment in money printing. We have seen in Japan that the only way to deal with the fading effect of QE is to apply more QE, which is why I have consistently argued since the day it was announced that “Abenomics” is an exercise in abject futility.

The old joke is of the two economists who meet on the street. One asks the other “How are you?” to which he replies “Compared to what?”. Economic success and failure are not about absolute numbers but are functions of expectations. We went into the crisis with an over-leveraged economy and we come out of it, if that is what we do, with one which is equally leveraged.

When the Fed begins to shed assets which it will do by letting bonds redeem rather than by actively selling, the refinancing will have to be done in the open market. As leverage in the system is being managed more stringently than it was prior to 2008, the cost of financing will rise and with it the proportion of fiscal revenues which is expended on servicing debt will impact on the financial flexibility of government.

I have always been a tad sceptical of the benefits of the trickle-down effect which was such an important part of Thatcherite and Reaganite thinking, but I don’t think it is that much worse than letting government redistribute wealth through taxation once the frictional costs of collection and disbursement have been accounted for. I once had the thought that if five civil servants share an office and each pays 25% tax, then the fifth one’s job is entirely financed by the other four. I digress.

The argument is that we need not worry about the size of the debt but about nothing other the cost of servicing it. With next to no inflation and hence no natural erosion in the debt pile, we will simply replace one economic and fiscal Gordian knot with another one. QE has, to wheel out another old chestnut, done nothing other than to kick the can down the road where expenditure exceeds revenue and the gap is filled by borrowing. Ending QE removes a major lender from the equation and anyone who thinks that they can demonstrate that this can be done entirely painlessly is either smoking dope or is in line for a Nobel Prize in economics.

With US CPI at 1.7% but the treasury curve not crossing that return level until somewhere in the 6-year area, the entire front end is showing negative real returns. This worked with the buyer of last resort hanging out there in size but it cannot persist. As noted, the risks are not in the end of QE but in the refinancing of debt currently owned by the Fed. The “Taper Tantrum” of 2013 missed that point entirely, but markets love to panic first, then think. The ratchet will tighten slowly and unperceptively.

As a very senior rates chap with whom I had a cracking dinner last night put it: “We’re in a bear market; it’s just that nobody knows it yet”.

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