In the past 18 months, one of the main factors behind the global economic slowdown has been the tightening of monetary policy, especially the 225bps hike and the USD 800bn of QT by the Federal Reserve. Growth expectations have constantly been revised to the downside, which has levitated price volatility in the past year and also generated sharp drawdowns in equity markets (i.e. the S&P 500 fell by 20% from peak to trough in the last quarter of 2018). In addition, the reduction in the Fed’s balance sheet has significantly reduced banks’ reserves held at the central bank, creating some volatility in money markets with the Effective Fed Funds Rate breaking out of its target range, implying that US policymakers have been losing control of short-term interest rates.
As a consequence, the Fed radically changed its monetary policy in the past year, from a ‘long way from neutral’ in October 2018 to ‘appropriate stance’ in January 2019. In addition, the Fed has cut twice since August, and market participants have been waiting for the next big move: the restart of QE. Even though many economists have argued that cutting rates and considering expanding the balance sheet when the unemployment rate is standing at a 50-year low and wage inflation keeps accelerating (wage growth is approaching 4%) was a tremendous mistake, we think that they have been ignoring two main issues.
The first one concerns the buyers of US Treasuries. In the past three years, the buyers of US debt have switched from the global public sector (i.e. central banks) to the global private sector (i.e. pension funds), and that participants have been speculating that there will not be enough balance sheet in the private sector to purchase the oversupply of US Treasuries. As a consequence, some investors have been anticipating that as the US government deficits have been soaring, the Fed was eventually going to step in to absorb the remaining Treasuries in the market.
In addition, low interest rates combined with the significant divergence in unconventional monetary policies run by the BoJ and the ECB over the years have put pressure on the exchange rates and the cross currency basis swaps (figure 1, left frame), and therefore increased the hedging costs for Euro and Japanese investors. Even though the 10Y yield on US Treasury bonds has nearly halved since the last quarter of 2018 (currently trading at 1.75%), it is still attractive for Euro and Japanese investors, where yields are trading at -50bps and -20bps, respectively. However, if we include the hedging costs, the final yield that Euro and Japanese investors would get is -1.2% and -1.1%, which is far worse than the local bond yield. Figure 1 (right frame) shows the series of the 10Y US that a Euro, UK and Japanese investor would get after including the hedging costs.
The second reason to relaunch QE is due to the drastic fall in (excess) reserves in the banking system. As a consequence of the Great Financial Crisis, the Fed stepped into the market and purchased financial securities in order to restore financial stability in the system and then reflate the economy. Through several rounds of QE, policymakers increased the central bank’s balance from $900bn in the second quarter of 2008 to $4.5tr in 2014. As the Fed had been purchasing, in net, financial securities from commercial banks, the increase in assets was matched by an increase in banks’ reserves held at the Fed on the liability side of the balance sheet.
Figure 1 (left frame) shows that the US monetary base, which is composed of the currency in circulation and the reserves of depository institutions, soared dramatically from $900bn in 2009 to over $4tr at the end of 2014. However, excess reserves have been drastically falling in the past 5 years, from a high of USD 2.7tr reached in August 2014 to USD 1.38tr today, raising fear that we were suddenly facing a shortage of reserves. Figure 1 (right frame) shows that the behaviour observed in money markets with the Effective Fed Funds Rate (EFFR) first rising above the interest on excess reserves (IOER) was mainly attributed to the low level of excess reserves.
There is clearly a negative relationship between the EFFR-IOER spread and the level of excess reserves. However, the impact of a negative change in reserves on the EFFR-IOER spread was minimal when reserves were standing above USD 1.8tr. The relationship has changed radically when reserves fell below the ‘fortress level’ of USD 1.5tr as the impact on the EFFR was more and more significant. Hence, investors concluded that in order to ease tensions in money markets, the Fed has to introduce QE in order to bring back excess reserves to $1.7tr/$1.8tr.
We saw that the Fed total assets have grown by nearly USD 200bn in the past month as a result of the recent repo operations, and different sell-side institutions have been speculating that the central bank will resume QE by the end of this year. For instance, JPMorgan estimates that the next purchase program will start in November this year and run for at least 6 months averaging USD 21bn in monthly purchases (figure 3).
The central bank announced on Friday that in order to address issues in the short-term lending market, it will be continuing its overnight funding operations through at least January 2020 and will be buying short-duration T-bills (from 5 weeks to 52 weeks) through the second quarter of 2020. In other words, QE has already started in the US (though policymakers do not want to call it QE), but longer-term maturity purchases should be announced in the coming meetings.
To conclude, even if the US is expected to grow by 3.5/4 percent in nominal terms (2% real) in the third quarter of this year with an unemployment rate standing at a 50-year low, leading indicators such as business sentiment (PMIs) and uncertainty have been forcing policymakers to ease in order to limit the expected downside and reflate the global economy. In addition, the scarcity of both reserves and collateral, which recently led to a spike in volatility in money markets, has increased investors’ fear of a global US dollar shortage. As a result, the Fed has started to grow the size of its balance sheet (again), and should resume purchases of (long-term) Treasury securities in the coming meetings.
The big question now is: will it be enough to cheapen the US dollar (UUP)? Figure 4 shows that the US dollar keeps reaching new highs in the current environment, weighing on EM economies heavily USD indebted (i.e. Argentina, Turkey, Brazil). We do not expect the US dollar to start weakening now as the elevated uncertainty keeps pushing demand for safe havens. The dollar has remained strong against most of the currencies (to the exception of the Japanese yen) and we expect it to remain strong until the end of the year. However, the trend might reverse in the beginning of 2020 as the global economic slowdown bottoms.
Disclosure: I am/we are short EURUSD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.