Barclays' Joseph Abate Muses: It's Not The Size Of QE2, It's How You Use It
In advance of today's FOMC statement which the entire market is waiting for with bated breath, specifically focusing on just what form any incremental quantitative easing will take (if any), Barclays' Joseph Abate once again steps back to observe the forest in avoidance of the trees, and asks the critical question: just what is the objective of this round of QE: is it to force down short- or long-term interest rates. And since the economic benefit of the former is minuscule, the Fed will arguable be focused on the latter, thus forcing Abate to ask how this can be best accomplished "without causing the disruptions that cropped up in the first round of asset purchases." The Barclays strategist also wonders if the purpose of a possible MBS monthly purchases on a periodic basis, rather than en masse, is merely to prevent a problem that has recently become prevalent: namely the surge in MBS trade fails, a phenomenon that has received surprisingly little attention lately, yet which as the chart below from Mortgage News Daily shows is become quite a major problem, and one which the Fed is certainly concerned about (and if it isn't it should be). In other words, most pundits openly ignore the very likely distortions that will arise from a wholesale attempt at pushing LT rates lower. Read on for Abate's open ended question, as well as his logic as to why possible QE forms, at least as presented by the general media, are likely to be woefully insufficient.
From Joseph Abate:
In thinking about another round of quantitative easing, the Fed would have to work through a few issues. First, it needs to decide what the objective is – is it to drive down short- or long-term interest rates? Second, if the goal is to pull down long-term rates – which would produce the most economic stimulus – how can this be accomplished without causing the disruptions that cropped up in the first round of asset purchases?
Given the current level of short-term interest rates, we think any additional stimulus designed to pull the funds rate, repo or bill yields lower by increasing reserve balances at banks would likely be quite small. First, the relationship between the overnight funds rate and the level of bank reserves has broken down. Not only are banks structurally long cash, but, volumes traded in the funds market have shrunk substantially, with only the GSEs as the biggest players. Thus, there is no need to target a specific level of bank reserves – it matters little to short rates whether the level of bank reserves stays at $1.050trn, goes higher, of falls by $200bn through year-end, as we expect. Second, we think there are more effective ways to pull short rates lower – either by cutting the IOER or by allowing the SFB program to expire. Both could drag short rates down without being tied to a reserve operation of a specific size.
Since short rates and reserve balances have become unmoored, and the stimulative effect of pushing these rates down another 10-15bp would be low, any additional QE from the Fed would mostly likely focus on bringing down long-term interest rates, where it could get more “bang for its buck”.
The Fed would then be resurrecting a key FOMC debate from 2009 – what matters more for long-term interest rates: the size of the Fed’s asset (MBS) holdings or the pace of their acquisition? If the size of the portfolio matters most, then the only reason to purchase MBS securities at a monthly rate rather than in rapid-fire succession might be to prevent the disruption its earlier purchases created by causing fails (or incomplete deliveries) to spike. Alternatively, the Fed could simply buy Treasuries where its purchases would be less likely to cause significant distortions. Regardless, re-engaging QE – even in the light version to keep the Fed’s balance sheet steady – may require a bit more thought than simply flicking a switch.
Markets have begun pricing in a small probability of some kind of Fed action by year-end with 3m OIS slipping 2bp to 17bp in the past month. At the same time, the December FF contract is very slightly inverted to the September contract. Discussions about what the Fed might do to prevent additional softening have focused on a QE ‘lite’ strategy of MBS (or Treasury) purchases to offset the shrinkage in the Fed’s balance sheet caused by prepayment roll offs. Our economists do not believe that growth will become sufficiently soft to justify another round of quantitative easing. Since the start of the year, reserve balances have remained fairly steady at 1.050trn (as of Wednesday, $1.038trn). More significantly, the Fed’s MBS portfolio, which peaked 3 weeks ago, is only $12bn lower.
Looking ahead to year-end, our mortgage strategists believe that at prevailing interest rates the Fed could see an additional $115bn in prepayments ($275bn annualized). Since prepayments shrink the size of the Fed’s portfolio, they permanently reduce the level of reserves in the banking system. Other components of the Fed balance sheet should also lead to a permanent shrinkage in reserves, including maturing Agency debt securities and the secular increase in currency in circulation. Adding in temporary swings in the Treasury and GSE cash deposits at the central bank, we look for aggregate reserve balances to shrink by almost $200bn by December, ending the year at $875bn. Thus, the QE ‘lite’ proposal being discussed in the press would have the Fed in the market buying approximately $23bn in either Treasuries or MBS each month – just to keep the Fed’s MBS portfolio from shrinking.