To Tantrum or Not to Tantrum, that is the QE
Five years from now, the pundits will be looking back and saying how obvious this all is. It’s not.
As QE comes to a halt and starts to wind down (US), lightly tapers (EU), or continues (Japan and maybe China) at the end of 2017, what happens? In fact, no one knows no matter how loudly they yell either nothing or apocalypse. There are too many variables, many of which are driven by human behavior and/or completely unknown. At the same time, if the previous posts at least somewhat justifiably tracked effects of QE through different channels, then presumably some clues on effects of halting and/or reversing QE can be found in the same channels.
Since the above hypothesized that the asset inflation channel was wide open during QE, that’s a good start. The bazillion dollar question is whether Fed withdrawal will mean a net loss of aggregate demand in asset markets, and if so which ones. Supply and demand would say yes, but supply and demand in 2017 is more complex than in 2009 when demanders were in short supply. Now there are a lot of them. The question is whether ongoing and growing demand for US assets will balance the slow withdrawal of QE. If the basic supply and demand equation does not change, little may occur. Let’s look first at where “substitute” demand might come from.
Foreign QE programs are one place to look. We don’t know what assets the sellers to EU and Japanese programs are turning around and buying, or whether they will continue to buy into US asset markets after the completion of the US Fed’s program. If there is a reckoning to be had with the end of Fed QE, ongoing global QE, among other sources of demand, can delay it. Any doubters whether foreign QE matters should consider that the SNB alone has acquired $80 billion in US equities through their program. US interest rate increases can ironically amplify the effects of non-US QE related asset purchases, as sellers of assets to foreign central banks seek yield as they rebalance their portfolios.
Years of QE in the US, record corporate profits, and asset sales at record levels (among other things), have led to considerable liquid assets on balance sheets. Some refer to this as an “ocean of cash” or “cash on the sidelines,” but in fact it’s all invested somewhere. It just may not be invested where its owners would ideally want it. The nearly $1 trillion in un-invested PE funds are one case. The money is presumably sitting in short term, liquid markets, looking for a higher value longer term home, but its current home is the best if can find. Redeployment could presumably help keep a floor under equity markets, though the effect on bond markets is even less clear. Entry from short into medium term bond markets as rates rise may help balance the Fed’s relatively slow withdrawal there.
Some believe that following the new US tax bill, gobs of money will enter the US further driving up asset prices. In fact, most of that money that the companies want in the US is already in US assets. It just happens to be registered in a foreign name. What repatriation might do is substitute for companies’ borrowing for share buy backs and lead to a retirement of debt (increasing liquidity) just as the Fed is trying to tighten it. Chalk another one up here for the “ain’t nothin gonna happen” camp.
If broad asset prices (outside of those intended) drop, the Fed itself may reappear on the demand side in the notorious Greenspan Put. Asset price growth has been popular, and asset price deflation will be even more unpopular than that. Central banks should be independent of the political process, but really? A sharp drop in asset prices across the board, especially if inflation remains tame, can trigger a slowdown in the taper or even a restart of QE. For fans of behavioral economics who have not figured out what to do with it, consider Prospect Theory. The Greenspan Put did not start with Greenspan. Remember, a major reason for increasing rates is so the Fed can cut them again. The real issue is not whether bond prices will drop, with an increase in interest rates they will for sure, but whether drops extend outside medium term bond markets.
Taking the above, the end of QE in the US may have little effect on asset markets or the economy, at least through the asset price channel. An ancillary is that the end of QE may at least initially have little effect on interest rates. Barring inflation, that’s OK. If inflation rises, that’s a whole different problem. In sum, QE inflated asset prices may stay high and market interest rates low until some other event occurs: a slowdown in corporate profit growth, defaults in a major market, trade war with China, baby boomers’ selling assets to pay for retirement, some global shock that raises risk premia again and wreaks havoc in the repo markets, or any number of other factors including oh so many that we cannot even guess at. That’s not the end of even this little story, besides that the above may be totally wrong. It’s also not a long-term assessment, just until things change, which they will. Even if aggregate supply and demand for US assets roughly stay where they are, more can happen as QE unwinds. A lot depends on whether policy and/or other rates go up or not. The Fed has some, but in no means full control over this.
The Fed is in fact actively trying to raise policy rates, not just unwind QE. Outside QE wind-downs, available Fed interest rate levers may have built in stops to them. Each 1 percent increase in the IOER leads to about $40 billion annually in cash payouts (not reserve increases, inside money) to banks. That at very least will make excellent press, and perhaps more populist calls for a revocation of independence. Though the technocrats at the Fed will try to “do the right thing,” preservation of the institution is an incentive that is never on the sidelines.
Regardless of what happens with QE, at least existing short to medium-term bond price levels will drop if the Fed is successful in raising anything other than short-term rates. That does not mean a readjustment of other asset prices, like equities and riskier assets for example, but it might. At this point, to try to make progress here we assume (this is not assured), that when the Fed unwinds QE and increases IOER, that other rates will follow. Let’s just say they do, then see what happens in our channels. Here is the really guessy part because it depends on highly unpredictable investor behavior.
The terms that need to get into this conversation are liquidity, volatility, and risk premia. Others have argued persuasively that the apparent liquidity in assets markets is delusional. Much of the liquidity that entered the market drove up prices and then stopped trading. Banks are no longer making markets the way they used to, many quant funds are trading rangebound, and the ever-popular ETFs’ actually infrequently trade in the securities whose index they track, just their own shares. Liquidity looks good, until you really need to trade. That’s an age-old problem, but indications are its gotten worse.
A QE driven shift in demand or interest rates may be enough to tip certain markets to where the liquidity delusion is revealed. It won’t take much, just a little shift away from high yield markets back to now higher yielding safer assets. That means volatility, and that means the return of the risk premium. Basically, it means a return to “normal” markets that traders are no longer used to. The most vulnerable markets are perhaps in high yield, emerging markets debt, possibly emerging markets equity, leveraged and low profit tech stocks, stocks leveraged with high yield debt, anywhere that risk premia have been compressed out of relationship to risk in a “normal” environment. The effects are mutually reinforcing, and we have seen them before. Volatility begets risk premia begets liquidity begets volatility, round and round. Even if there is potential liquidity, real demand may fail to appear in certain markets. The S&P 500 and AAA corporate markets may be unaffected, depending on where collateral lies. Markets will become bifurcated by risk, unlike now. The elephant in the risk room is that no one really believes that the, for example, 100- year Argentinian bond is going to make it 100 years, but in the current market it does not need to. It should need to.
Let’s look at the reversal of a couple of effects. The first is in channel 2, and the wealth effect. If increases in the wealth effect only had a minor impact on the consumption and investment spending that drives GDP, then a reversal should be similar. In theory that is correct. However, investors and consumers tend to react more negatively to a decrease in wealth than they do positively to an increase in it. That brings us back to Prospect Theory. If correct, then a QE driven run up in asset values can be a devil’s bargain and even if inflationary asset markets are mildly stimulating, deflating markets can be proportionately more depressing. Again, it depends on what else is driving the economy forward. If it is enough, the withdrawal of QE may not matter.
Channel 3, and the business financing effect enter in. As rates go up, companies in marginal markets and sectors can struggle with higher interest payments. They can also see their loans called or not rolled over, as investors see other financing options. If there are defaults, or the perception of risk, risk premia will increase, further increasing rates, further increasing distress, and so on. At very least, both interest and risk premia increases will stymie further investment in marginal, high risk areas. And it should. Effects on repo and money markets, flash back time, will depend on how repo lenders have been treating high risk collateral.
A channel not previously mentioned is interest rates’ effect on government spending, mainly because this is less of a concern when the economy is depressed. Lower rates don’t directly stimulate spending, though may make it easier to sell politically. When rates go up, given the extent of short-term government borrowing so does interest expense. Either the deficit increases, or spending on other items decreases. As a major component of GDP, a reduction in government spending would all other things equal reduce economic activity.
Above, it was noted that lower rates have not been particularly good for retirees or those getting close to it. The asset base may be worth more, but yields are down. If rates go up, presumably so will yields, but on newly purchased assets. Existing assets will just be worth less. Again, if you are a believer in prospect theory, higher yields may not make the 50+ crowd spend more, but rather double down on savings to get to “the number” they think they need to retire.
Again, the answer is we don’t know. One conclusion we could perhaps draw though is that all this QE has created some potential fragility in the system, to borrow the term from Nicholas Taleb. By that, the distribution of future volatility might well be lopsided as QE comes to an end, with most of it piled up on the downside. Rates and risk premia are not going down, bond prices are not going up, at least some liquidity is leaving the system, taxes are not going down again, and a wide range of asset values are at historical highs. Though the status quo could continue for some time and no immediate triggers are apparent, it appears the risks are asymmetric at this point.