What's Next for the Dollar, Stocks, Bonds and Gold?
Washington (July 16) The Fed’s “balance sheet reduction” may have profound implications for the dollar, gold, stocks and bonds. We provide an outlook.
It is said forecasts are difficult, especially when they relate to the future. Investors might want to pay attention nonetheless, not so much because I believe I have a crystal ball, but because investing is about managing risk. And there’s a risk that I’m right.
Quantitative Tightening
There’s a lot to cover, so let’s start with what is perceived to be the elephant in the room, the Fed. In suggesting that the Fed would soon initiate balance sheet reduction, Fed Chair Janet Yellen indicated it would be like watching paint dry on a wall. Duly observant, numerous pundits agreed. With due respect, that’s a bunch of baloney, but judge for yourself. Unless markets fall apart in the coming weeks, we expect that the formal announcement for the Fed’s balance sheet reduction will be made this September, with a gradual stepping up in the amount the Fed will allow to “run off”, i.e. the amount of maturing bonds it won’t re-invest. The Fed has left many details open to interpretation, but looking at Treasuries alone, at first, $6 billion may be allowed to run off; this is gradually stepped up until $30 billion a month may be allowed to run off. It’s not clear at what duration maturing bonds will be reinvested that are above the threshold, but it is plausible to roll those excesses to “fill the gaps” in subsequent months. Differently said, it’s perfectly possible that the Fed will indeed allow $30 billion in Treasuries to run off once the program is fully deployed:
In addition, the Fed will allow mortgage-backed securities to run off (MBS). There’s really no good reason to look at Treasuries and MBS in isolation; as such, the balance sheet reduction would be $50 billion a month if the program were to be fully deployed:
The Fed hasn’t announced how small a balance sheet they want to have; based on our interpretation of discussions of current and former policy makers, this is because the Fed neither knows, nor agrees of where they want to take the balance sheet. It apparently doesn’t stop the Fed from preparing the markets that they embarking on this journey because they believe they have years to make up their mind. Notably, as can be seen from the chart above, they might have until 2021. Basically, the Fed can reduce its balance sheet until excess reserves have been eliminated (this level varies on economic activity; the dashed line represents the current level of excess reserves and the potential maximum reduction holding all else equal). Whether the Fed will try to get excess reserves to zero or some other amount is an open question that not even the Fed appears to be able to answer internally.
If reducing the Fed’s balance sheet at a rate of $50 billion a month is akin to watching paint dry, what then is the ECB’s activity of purchasing €60 billion a month (its current rate)? Either the Fed or the ECB is pulling our leg here. If printing money is quantitative easing (QE), then balance sheet reduction is quantitative tightening (QT). There has been a lot of debate of what sort of impact QE actually has. Skeptics of QE have pointed out that all bonds trade relative to one another, i.e. an MBS might be a substitute to a Treasury bond which in turn might be a substitute to a German bund; applying a given spread, one can take that exercise further to any number of seemingly “safe” bonds, recognizing that safety is not an absolute concept (and from a US regulatory point of view, only US Treasuries are considered “safe” as the US government can always print money to pay it back). It’s in this context that the buying of MBS has been criticized as a useless digression from monetary into fiscal policy. Useless because spreads between MBS and Treasuries haven’t been meaningfully impacted; and a digression into fiscal policy because buying MBS rather than Treasuries is fiscal policy given that credit is allocated to a specific sector (housing) of the economy, something in the domain of Congress, not the Fed.
So has Yellen suddenly become a critic of QE by suggesting QT is akin to watching paint dry? I doubt it; much rather, the Fed does what it continuously has been doing since the financial crisis: try to convince the markets with words. If the Fed tells you, rates rather than QT is the primary tool to set rates, it must be true, right? Please just look at the rates, ignore everything else. In the meantime, across the pond at the ECB, Draghi will tell you with a stern look that QE is responsible for everything good that has happened in the Eurozone (and that he isn’t responsible for any bad side effects). You shall be excused if you are scratching your head.
It’s all about risk premia
I am in the camp that believes QE has been all about compressing risk premia, i.e. the spreads between risky and so-called safe assets. With QE, junk bonds trade at less of a premium over bonds; with a #WhateverItTakes attitude, peripheral Eurozone bonds trade at less of a premium over German bunds. And equities trade at higher valuations and lower volatility? Sound familiar? Not too surprisingly then, the market has had some tantrums when the Fed first started talking about tapering; or when the Fed indicated it might start raising rates.
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