Pragmatic Capitalism

Capital for Living a More Practical Life


By David Schawel, CFA, Economic Musings

Every passing speech by chairman Ben Bernanke or release of the latest Fed minutes comes with the increasingly obvious reality that the market is 100% fixated on the Fed.  This assertion is less than shocking but important when you ascertain the ramifications of future monetary policy outcomes.

Is more QE needed? This is the question that I don’t claim to know and glad I don’t need to answer.  What I do know is that the Fed has already gone down this road as their main form of monetary easing.  Before I posit the implications of no new asset purchases or asset sales, let’s review what has happened thus far.

Mechanically, the Fed has purchased ~15% of the $5.5trillion Agency MBS market in addition to US Treasuries.  These bonds were sent to the Fed, and the Fed paid the sellers of these bonds with newly created reserves, also referred to as “printing money”.   So a large % of the systems risk free bonds were sucked out of the system and replaced by “excess reserves”.  Implications of QE?

1. Financial Repression – this term which has been adopted by Wall Street strategists such as David Zervos & Harley Bassman essentially means that the Fed has been effective in terms of lowering short & long term interest rates and reducing income to banks, pension funds, endowments, insurance co’s and savers galore. Everyone can see record low rates in almost every fixed income class.

2. Increase Disposable Income for Americans-  Driving down primary mortgage rates (for those who qualified) obviously had an impact of transferring income from MBS holders directly into the pockets of borrowers who could refi at substantially lower rates.  Millions of homeowners have dropped their mortgage payments by hundreds of dollars per month.  This was by no means perfect (see HARP failures etc), but at least beneficial for some.

3. Increase Wealth Effect / Prop up Asset Prices-  Buyers of Agency MBS & Treasuries have been pushed into IG Corporates, High Yield, Muni Bonds, Non-Agency MBS, and all the way down the spectrum.  When 15%+ of a major asset class is bought out of thin air, these former holders need to go somewhere. All attempts have been made to drive investors into risk assets, this is clear and indisputable.  BTW, ever look at a chart of gold compared to the Fed’s balance sheet? Striking resemblance.

What happens if the Fed Sold Bonds?  Let’s pretend inflation was running higher and unemployment had come down notably.  The Fed wants to drain excess reserves, and they begin to sell bonds.  Reserves get sent back to the Fed (aka money burning!), and bonds get sent back into the market.  Supply of Agency MBS and UST’s is greater and prices begin to fall/yields rise.  After all the supply has increased overnight and it needs to be filled by someone.

Now the incremental demand that has flowed into risk assets can just as easily leave that asset class.  Let’s assume the impact of the Fed selling bonds caused mortgages & treasuries to rise by 200bps.  So 30yr current coupon MBS that were trading for 3% were now up to 5%.  Would buyers of non-agency MBS at 6% or high yield at 6% rather stay in these credit assets or take a comparable yield with an explicit government backing?  The major point here is that the Fed has done a spectacular job in driving up asset prices in risk free assets (Agency MBS, Treasuries) causing risky assets to appear attractive.  Nevertheless, this relationship works both ways and is dependent upon the Fed maintaining the size of their balance sheet.  A reversal of this would deflate the asset prices just as quickly as they rose.

I don’t believe the Fed will sell bonds.  In fact it would create a rush to the exit of epic proportions.  It is for this reason that the Fed has tested reverse repo’s to see if it would be able to remove liquidity from the system.  Should the Fed stop re-investing runoff from the Agency MBS portfolio it would be a slow removal of excess reserves.  As the MBS prepay, reserves would be sent to the Fed and drained from the system.  This is the most likely, but is still probably a year or two away.

Conclusion: I believe the Fed is in a difficult position.  They cannot realistically sell bonds if the economy heats up.  They are essentially “all in”.  Now what happens if rates continue to back up as the market believes that Bernanke’s “promise” of rates low until 2014 will not be upheld?  The market has enjoyed the benefits of the Fed propping up risky assets, and at the current time appears to be forgetting about this aspect.  There is real risk to prices across the spectrum when participants realize that this sugar high might not be returning.

Even beyond asset prices, can the economy handle rising interest rates?  Housing affordability is already at an all-time high, but would a 75bp rise in rates start to choke out this housing recovery from higher primary mortgage rates?  Would Bernanke & Co be okay with a slowly improving economy if the equity markets sold off from a lack of additional QE?  We know QE has had a large impact but its clearly uncertain how a recovering economy will react without an additional dose of this accommodation.  Will the economy flourish without these “training wheels” or will it veer off course?

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