Posts filed under “Think Tank”

Tapering Is Now Tightening

Tapering Is Now Tightening
David R. Kotok
July 19, 2014

 

 

For a long time, as we saw it, tapering and the threat of tapering (as in last year’s taper tantrum) did not constitute tightening. Today we explore why we believe the situation has now changed.

In order to understand why tapering was not tightening initially, we must momentarily set aside all influences on US Treasury note and bond interest rates that fall outside of the Federal Reserve’s program. Pretend for a minute that foreign exchange flows, geopolitical risks, inflation expectations, deflation expectations, sovereign debt biases, preferred habitat buyers, and a million other things are all neutral. They never are, but for this exercise pretend that they are so.

We have observed and commented on QE and the expansion of the Federal Reserve’s balance sheet for several years, as the Fed emphasized intermediate- and long-term maturities as a mechanism by which to absorb the net issuance of US Treasury securities.

Let’s think of it this way. The federal deficit was $1 trillion, and the Fed was buying securities at the rate of $85 billion per month, or approximately $1 trillion yearly. Thus, the Fed purchased the entire amount of issuance that the federal government presented to the market. If all things were otherwise neutral, the market impact was zero. There was no influence to change interest rates; hence they could stay very low.

But in the economic recovery phase, the federal deficit commenced shrinking sooner than the Fed commenced tapering. There reached a point at which the Fed was acquiring more than 100% of the net new issuance of US government securities. At that point, the Fed’s buying activity was withdrawing those securities from holders in the US and around the world. Essentially the Fed was bidding up the price and dropping the yield of those Treasury securities, and it was doing so in the long-duration end of the distribution of those securities.

The Fed has taken the duration of its assets from two years prior to the Lehman-AIG crisis all the way out to six years, which is the present estimate. It is hard to visualize the Fed taking that duration out any farther. There are not enough securities left, even if the Fed continues to roll every security reaching maturity into the longest possible available replacement security. We can conclude that the duration shift, otherwise known as a “twist,” is over. A six-year duration of the Fed’s balance sheet is about all one can reasonably expect them to obtain.

Now the Fed commences the tapering process, incrementally stepping down its purchases of $85 billion per month to lesser amounts. The Fed has said that it will complete that task and reach zero before the end of this year. The target month is October. The current rate of purchases is $35 billion a month, or approximately $400 billion at an annualized run rate.

The federal deficit has declined as well. Because of the shrinkage of the deficit, the run rate of Fed purchases and issuance by the US government are still about the same as the amount of Fed purchases. Before, the balance was $1 trillion issued and $1 trillion absorbed by the Fed. Presently, it is approximately $400 billion issued and $400 billion absorbed by the Fed. The Fed is on a glide path to zero, but the deficit remains a long way from zero. In July, August, September, and October of this year, for the first time, the net issuance of US government securities will exceed the absorption by the Fed as it tapers.

The process of tapering is a gradual one that has been discussed by Fed officials continuously, and it is clear that, in the absence of some extreme reaction, they are going to sustain this path. What does that mean?

By autumn, we will see issuance of US government securities at a rate of somewhere close to $400 billion annualized, whereas Fed absorption will be at zero. The Fed will continue to replace its maturities, but that practice will not add duration or supply any stimulus.

In July, August, September, and October, for the first time, the change in rate between what the Fed absorbs and what the Treasury issues will result in a shift. That shift is a tightening.

Will the markets respond to that tightening? We do not know. Have they responded to similar shifts in history? Absolutely. Could the shift be dramatic? We do not know. Could the response be benign? Yes. Could the response increase volatility and intensify market reactions to other events, many of which we have, for the purposes of this discussion, been assumed to be neutral? Absolutely.

We are about to get back to a neutral place. The neutral place means the impact of issuance of debt by the government will again become a significant factor even if the rate is $400 billion per year. The other factors that we listed above and many more that have not been listed here are about to become more direct and substantial influences on interest rates. The reality is that their effects over the last seven years have been dampened by Fed policy.

The effect of Fed policy on US-denominated assets has been to create a continued upward bias in the prices of those assets. Stocks, bonds, real estate, collectibles, and any asset that is sensitive to interest rates have had the benefit of this extraordinary policy for five or six years. That support is coming to an end.

At Cumberland, we have no idea whether the transition will be benign and gradual or abrupt and volatile. There is no way to know. Therefore, we have taken a cash reserve position in our US ETF and US ETF Core accounts. We are maintaining that position as we navigate this transition period of July, August, September, and October. After years of stimulus, we’ve reached a tipping point that remaps the investing landscape in ways we cannot clearly foresee: for the rest of this year, tapering will be tightening.

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David R. Kotok, Chairman and Chief Investment Officer

Category: Bailouts, Credit, Federal Reserve, Fixed Income/Interest Rates, Think Tank

The Losers From U.S. Sanctions: AMERICAN Businesses

U.S. Sanctions Against Foreign Nations Are Hurting American Companies Who are the losers from U.S. sanctions?  American companies. Two giant U.S. business groups – the U.S. Chamber of Commerce and National Association of Manufacturers – ran ads in the New York Times, Wall Street Journal and Washington Post protesting sanctions against Russia.  These are not…Read More

Category: Think Tank, War/Defense

Bank Counterparties and Collateral Usage

Bank Counterparties and Collateral Usage Hamed Faquiryan and Marius Rodriguez The 2007–09 financial crisis drew attention to the nature and consequences of connections among financial firms. New reporting standards set in the wake of the crisis have shed more light on these ties in current financial markets. New data are available on the magnitude of…Read More

Category: Credit, Think Tank

Kiron Sarkar’s Weekly Report 19.7.14

China’s GDP rose by a better than expected +7.5% in Q2 Y/Y and was welcomed by markets. The improvement reflects the stimulus programme undertaken by the government and the sharp rise in lending, once again, as a result of government policy. The government’s actions suggests that they will continue with their stimulus programme/increased lending if…Read More

Category: Markets, Think Tank

Should the Fed Do Emergency Lending?

Category: Think Tank

A College Education Saddles Young Households with Debt, but Still Pays Off Daniel Carroll and Amy Higgins     Many parents believe their children must get a college degree—especially if they want to have at least as comfortable a lifestyle as their parents had; yet the price of a college degree has been rising rapidly…Read More

Category: Economy, Think Tank

Category: Think Tank

What Exactly Are Spy Agencies Actually Doing?

What Exactly Are the Spy Agencies Actually DOING with their Bag of Dirty Tricks? SPECIFIC EXAMPLES OF WHAT THEY MAY BE DOING Newly-released documents from Edward Snowden show that the British spy agency GCHQ has developed numerous offensive digital tools. But what exactly are they doing with these dirty tricks? We think it’s important to…Read More

Category: Think Tank, War/Defense

Hong Kong – The Peg is Not Likely to be Changed

Hong Kong – The Peg is Not Likely to be Changed By Peter T. Treadway July 15, 2014       In my opinion, the Hong Kong dollar peg, which has been set since 1983 to the US dollar at 7.80:1.00,   should and will remain unchanged. There are sound economic reasons for this but…Read More

Category: Currency, Think Tank

How Fat is the Top Tail of the Wealth Distribution?

Category: Taxes and Policy, Think Tank, Wages & Income