What Can QE Tell Us About QT?

Authored by Peter Cook via RealInvestmentAdvice.com,

In “The Fed’s Real Target” it was explained that the Fed’s interest rate manipulations are intended to influence the behavior of borrowers, not investors.  Fed Chairman Powell agrees.  In his most recent press conference, Powell reiterated that the Fed Funds rate continues to be the Fed’s primary tool to influence the U.S. economy.  Based on the Fed’s analytical framework, the economy is slowed by a series of interest rates increases because the behavior of borrowers is constrained.  Using similar logic, the economy is stimulated by a series of interest rates declines because borrowers use the reduction in interest expense for other purposes that promote economic growth.

But the Fed also bought a non-trivial amount ($3.6 trillion) of government obligations during the Quantitative Easing (QE) experiment, in the belief that QE would also boost the U.S. economy. Unlike interest rate manipulations, QE is direct manipulation of bond prices and yields and is clearly directed at investors, not borrowers. This key difference between who QE and QT targets are incredibly important and often not fully appreciated by investors.

Since November 2017, the Fed has embarked on Quantitative Tightening (QT), a policy that forces investors to refinance trillions of U.S. government obligations that are maturing from the Fed’s portfolio.

Can the movement of asset prices during the QE period give clues about how asset prices might move during QT? 

In this article, we show that the Fed’s QE policy produced the counterintuitive result of higher yields on Treasury bonds, not lower yields as implied by supply/demand analysis.  Using symmetrical logic, the Fed’s QT policy should be expected to reverse the effects of QE, and to produce the counterintuitive result of lower yields, not higher yields implied by supply/demand analysis.

QE was launched in 2008 and ended in late 2014 after three rounds of purchases plus Operation Twist which extended the duration of their holdings  Digging through the archives, the following chart shows that the S&P 500 index (SPX) rose 176% during the periods in which QE was operative (colored lines) while SPX declined 32% during non-QE periods (gray).  Since mid-2015, when the chart was created, SPX has risen from 2100 to 2785, a gain of 31% that offset almost all the 32% loss.  Clearly, QE produced an upward bias to stock prices. While the topic for another article, it is worth pointing out that many other central banks continued buying assets after QE ended via their QE programs and this activity played a role directly and indirectly in supporting SPX.

Moving to the market for U.S. Treasury bonds, QE produced quite a different result than many had expected.  The 10-year Treasury yield rose by 184bp during periods of QE and fell by 293bp during non-QE periods.  Despite massive bond purchases by the Fed, sales by other investors overwhelmed the Fed’s actions.  Since mid-2015, when the chart below was created, 10-year Treasury yields have risen from 2.25% to 2.85%, offsetting some of the decline in yields that occurred during non-QE periods since 2008.

Why might yields have risen during periods of QE, when the Fed was buying trillions of dollars of bonds?  The chart below shows that inflation expectations rose by a total of 274bp during periods of QE and fell by 104bp during non-QE periods.  Markets apparently believed that QE would produce a systematic increase in inflation.

Summarizing the results of stock and bond markets post-2008, during QE periods, the Fed bought $3.6 trillion of government obligations, but bond yields rose.  During non-QE periods, bond yields fell.  Almost nobody expected that a multi-trillion program of buying government bonds would result in declining prices (rising yields) for government bonds.  Yet that’s what happened.  Based on the movement in breakeven yields, investors believed QE would result in systematically higher inflation.  During QE periods SPX rose, and during non-QE periods SPX was basically unchanged.

Viewed from the perspective of a portfolio, QE clearly changed the risk tolerance of investors, who sold U.S. Treasury bonds to the Fed and used the proceeds to buy U.S. stocks and a variety of other risky assets that appreciated sharply (real estate, junk bonds, emerging market stocks and bonds, collectibles, etc).  To use technical language, the risk premium fell for risky assets relative to U.S. Treasury bonds.

Transition from QE to QT

Since November 2017, the Fed has been pursuing a policy of QT, allowing a portion of its portfolio of bonds to mature without reinvesting.  If QT is the opposite of QE (essentially, bond-selling instead of bond-buying), it is logical that asset prices will adjust in the opposite direction than what occurred during QE.  That is, bond yields should fall even though the Fed’s actions require investors to now buy $50 billion more of government obligations each month.  Stock markets should fall because investors will sell risky assets to meet the increased supply of Treasury bonds.   But what is the actual pattern of prices in the QT era?

SPX has risen by approximately 5% since November, but more than 100% of that gain occurred in December and January, possibly in anticipation of corporate tax cuts.  Since January, the trend has been downward and much more volatile.  QT began slowly, at $10 billion per month, but starting in July 2018 it has been ramped up to $50 billion per month in maturing bonds.  QT may already be taking a toll on the stock market.

How about the bond market?  The combination of higher deficits, higher short-term interest rates, and the Fed’s QT program means that investors will need to buy more than $1 trillion in newly-issued Treasury notes in each of the next few years.  A simple supply/demand analysis would suggest that bond yields should rise during a period of QT, just as a simple supply/demand analysis would suggest that bond yields should have declined during QE.

As shown below, bond yields have indeed risen since the beginning of QT, from 2.40% to 2.85%.  But just as with the stock market, most of the move occurred in December and January, as markets began to anticipate the stimulative effect of corporate tax cuts.   Since January, bond yields have gone sideways, defying the predictions of those who believed long-term interest rates would inevitably rise because of the Fed’s rate hikes and increased deficit spending, each of which increases the supply of U.S. Treasury bonds.

Are the bond markets expecting a return of inflation?  The chart of inflation expectations below is remarkable because inflation expectations have remained in a narrow range of 1.5-2.5% for most of the past 15 years.  As a result, relatively small changes can appear to be larger than they really are.  During the entire QE era, inflation expectations were also anchored in the 1.5-2.5% range, although as explained previously, inflation expectations rose during QE periods and fell during non-QE periods.  Since QE ended in late 2014, inflation expectations fell from 1.8% to 1.2% as the price of crude oil crashed from $110 to $26 per barrel.  Inflation expectations then rose to the current 2.1% level. That said, QT seems to have put a lid on rising inflation expectations, which have been stuck at 2.1% for the past six months.

Many, including the Fed, fear that inflation will spike higher.  But the ever-flattening yield curve, which is an excellent leading indicator of recessions, suggests that bond markets are beginning to believe that the next move in inflation is down, not up.  The flat yield curve also supports our analysis in “Does Surging Oil Costs Cause a Recession?” which shows that a combination of rising short-term interest rates and a doubling of crude oil prices preceded each recession since 1970, with no false signals.  Those conditions exist in 2018.

Finally, the prices of industrial metals such as copper are nosediving.  Many will attribute the recent weakness in metals to the threats of a trade war.  But it is also possible that the Fed’s combo-platter of QT (aimed at investors) and rising U.S. interest rates (aimed at borrowers) is a primary culprit.  Regardless whether the trade war or Fed actions are responsible, it is clear that commodities investors don’t like what’s on the menu.

Conclusions

The purpose of this article is to estimate the future direction of asset prices based on the logic that QT will have the opposite effect on asset prices then occurred during QE.

Here’s what we know happened during QE:

  • QE changed the behavior and preferences of investors, which greatly affected relative prices

  • QE produced an expected result of higher stock prices

  • QE produced an increase in inflation expectations, which produced the unexpected result of higher Treasury bond yields

If markets respond to QT symmetrically to how they responded during QE, then:

  • QT will change the behavior and preferences of investors and change relative prices

  • QT will produce lower stock prices

  • QT will reduce expectations for inflation, resulting in lower Treasury bond yields

So far, the QT era has not produced lower stock prices and bond yields.  That said, it is too early to make a definitive statement on QT’s ultimate impact.  The full force of QT ($50 billion per month) has just begun, and there are signs that stocks and bonds are beginning to change direction.  Since November when QT began, SPX has risen.  But since the January peak that occurred in the wake of tax cuts, the trend of SPX is downward and more volatile.  Since November, bond yields have also risen.  But as with SPX, since January a change has occurred; bond yields have stopped rising.

It is possible that the trends in effect since January will persist and possibly intensify throughout the QT era, which would be a surprise to the consensus view that interest rates will inevitably rise due to an increasing supply of Treasury bonds.  Other important data points also suggest that Treasury bond yields may continue to fall; inflation expectations have been static since QT was launched in late 2017, the yield curve continues to flatten to levels not seen since 2007, and industrial commodities are in freefall.

Comments

t0mmyBerg Algo Rhythm Fri, 07/13/2018 - 22:54 Permalink

While I agree that the Fed is basically the root of all evil, I mean who thinks we need a 1930s style price control board to set the price of overnight loan funds for banks, a la wheat or raisin price control boards, the only person too stupid to be on ZH is the author of the article.  This is the second article I have seen that mentions $50 Billion in QT starting in July.  Oops wrong.  Read the latest FOMC minutes.  $26B in Treasuries and $14B in MBS.  That adds up to $40B, not $50B.  $50B starts in October, just as the Fed has always said it would be.  Started at $10B and rises $10B per quarter until it reaches $50B, in October.  Not now.  How can you trust anything said by someone who doesnt have the very most basic facts straight

In reply to by Algo Rhythm

itstippy Fri, 07/13/2018 - 18:14 Permalink

QE proved to everyone that the Federal Reserve and the Federal Government are willing to bankrupt the public till in order to save asset values in a financial crisis.  The wealthy(er) asset-holding class takes precedence over the working class and future generations.  This is also true in Europe and in Japan.  Now we know; hedge accordingly.

desertboy itstippy Fri, 07/13/2018 - 18:21 Permalink

Their analysts have continued, since this process started, to publicly repeat the mantra, "we are a data-driven organization."  The disingenuous, and meaningless, nature of this continually parroted phrase is quite telling of their internal conversations.

We do not need to explain our deliberations; We are always right; When something bad happens - we are victims of an anomaly in the data.  We are beyond reproach.  

This is definition of sociopathic narcissism.

In reply to by itstippy

Iskiab itstippy Fri, 07/13/2018 - 19:00 Permalink

True but that was a political decision, and politics change.

Politics usually revolve around making the baby boomers happy, so protecting the middle class pensions right before retirement makes sense.

The priorities of those in power might change, and allow a market crash.  It’s anyone’s guess.  These days whenever the market looks like it’s about to become bullish Trump sabre  rattles about trade, almost like he’s trying to take some of the air out of the market.

In reply to by itstippy

Balance-Sheet Fri, 07/13/2018 - 18:16 Permalink

QT is likely to be scrapped pretty quickly. The federal deficit is one part of UST cash demand so they need to find 1.2 T USD (apparently) and if 600B are going to be sold off from the Balance-Sheet then it will be no less than 1.8T so where is that going to come from? At the minimum you would have to toss the least qualified borrowers off the mortgage rolls. With the trade situation one would not expect deep pocket volunteers from evil Germany and evil China to step up so where does all this money come from?

If it is correct that the Fed is NOT going to purchase it who will be purchasing it? You COULD load the distribution channels the the major banks :-) but what is the plan?

Clock Crasher Fri, 07/13/2018 - 18:20 Permalink

Whatever is going to happen, its been studied in a think tank lab owned and operated by the most anti human forms of consciousness in the cosmos in advance.  

Whatever arises in the aftermath is not good for mankind.  Likely a cashless, depopulated control grid straight out of the good ol playbook. 

tahoebumsmith Fri, 07/13/2018 - 18:28 Permalink

Ponzi Postpartum Syndrome .... 

The FED is completely naked now with no where to go and no where to hide just a big ass pile of FIAT debt that can never ever be repaid .

Quantify Fri, 07/13/2018 - 18:42 Permalink

Don't care I have a fixed 3.4% home loan. A 1.9% auto loan, they aren't ever coming back at those levels. I have bought my one and only new vehicle in my lifetime, it should last till I die. The past is past.

Idiocracy's Not Sure Fri, 07/13/2018 - 18:57 Permalink

the Fed’s interest rate manipulations are intended to influence the behavior of borrowers, not investors.....That sounds a bit like the predatory lending that caused the 2008 financial crisis....BWWAHAHAHA

slobbermut Fri, 07/13/2018 - 19:21 Permalink

"So far, the QT era has not produced lower stock prices and bond yields.  That said, it is too early to make a definitive statement on QT’s ultimate impact.  The full force of QT ($50 billion per month) has just begun, and there are signs that stocks and bonds are beginning to change direction."

 

Above my pay grade...but what the hell happened to 'the market looks 6 months ahead'?  Guess not any more...now they are 'looking' behind a few months I guess; or possibly it is all BS anymore and the so-called market does whatever TPTB decide they want it to do regardless.

besnook Fri, 07/13/2018 - 19:40 Permalink

qt will result in higher long term rates as the fed will have to lengthen the term of their obligations and buyers will want higher rates to coax them into buying it.

Yen Cross Fri, 07/13/2018 - 19:42 Permalink

  This shit makes we want to puke. The Fed. spent $trillions at the rate of $100b per month for several years, and now everyone is freaking out over withdrawing 1/2 of that per month, and the QT has just started.

Balance-Sheet Yen Cross Fri, 07/13/2018 - 20:03 Permalink

In order to finance the US budget deficit at 100B per month (actual UST demand) and sell 50B a month off the Balance-Sheet someone must create 150B in loans monthly to purchase these assets. So who will step up here? This will have to go on for many years- six or seven years.

If it is internal US lending then there will be a sharp recession as the UST/Fed Complex destroys 50B a month for 72 to 84 months. When the Fed sells an asset the money it receives is cancelled.

600B per year is a lot of money even at today's gasoline prices and another 1200B to cover UST funding demand and internal transfers which can only go higher.

In reply to by Yen Cross

moonmac Fri, 07/13/2018 - 20:59 Permalink

When it got this slow at work(PVF Industry) QE1 saved the day. It slowed down again and QE2 boosted sales. A real bad lull arrived and QE3 quelled it. Operation Twist(QE4) was stabilizing insurance but then our economy slowed down again . Trump revived it and talk of shortages ruled the day until we realized it never came to fruition so his Tax Cuts attempted to reduce market anxiety but the truth is most of us are patiently waiting for the financial turmoil to really begin.

McDuff71 Fri, 07/13/2018 - 21:33 Permalink

...PPT doing the BTFTWD or any dip to the daily retail sheeple in order to offload what they have hoarded at the highest possible price...i reckon we'll continue to see this play out for some time yet - joe public getting fleeced while he thinks the sun is shining...when will we learn???

Ron_Mexico Fri, 07/13/2018 - 22:27 Permalink

this guy's not taking into account how this collides with long-term interest rate cycles, which have bottomed. The most QT can do is mute the increase in rates.

JailBanksters Sat, 07/14/2018 - 07:01 Permalink

I'm a believer in the QE to infinity model, they can't get out.

There's a huge world wide revolt against the Jews right Now, and the Feral Reserve is owned by same.

It's in the Jews best interest to NOT crash the plane, if they crash it, the Jews are toast.

There is only one way out, War !, a big War, a real War, not this mamby pamby terror BS Bush, Obama,Trump have been doing.

Fake Money backed up with a promise of more Fake Money, that's the ticket.