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After the US payrolls come the QE-cries.
Analysts and economists seemed to be falling over themselves over the weekend in their haste to call for more unconventional monetary policy ahead of the Federal Reserve’s meeting on Tuesday.
FT Alphaville have grabbed some of the more interesting/relevant notes and laid them out below, with our highlights. It’s a long read, but should give you an idea of the, err, QE II intensity.
First up is, Goldman Sachs economist John Hatzius. He of the famed non-farm payroll prediction skills is now "counting on” additional monetary support. As he put it over the weekend :
. . . On Friday, we revised down our forecast for 2011 and now expect a more gradual acceleration to a 2¼% pace on a Q4/Q4 basis, versus about 3% previously. (We also made a corresponding upward revision to our unemployment forecast and a largely technical upward revision to our core inflation forecast, although we still expect significant further core disinflation to ½% year-on-year by late next year.) The reason for the growth downgrade is that the deterioration in the economic data has coincided with a deterioration in the fiscal policy outlook. By our estimates, fiscal policy"”federal, state, and local"”added an average of 1.3 percentage points to growth from early 2009 to early 2010 but will subtract an average of 1.7 points in 2011. This number is based on the assumption that the upper-income income tax cuts passed in 2001-2003 expire on schedule and emergency unemployment benefits end in late 2010, but that all other tax cuts including the Making Work Pay program passed in early 2009 are extended. These assumptions are subject to risk in both directions. Depending on the outcome of the November election, it is possible that Congress will decide to extend all of the tax cuts, which would modestly boost the growth outlook, but it is also possible that stalemate ensues and all tax rates rise on January 1, which would substantially hit growth.
The risk of a double-dip recession is material, but ultimately the more likely outcome is that we will manage to avoid it. This is partly because the cyclical parts of the economy, which typically account for "more than all" of the decline in real GDP in a recession, are already very beaten down. The most obvious example is homebuilding, where another drop of the magnitude typically seen in recessions is almost mathematically impossible. But auto sales, equipment spending, and nonresidential construction are also at levels implying that the capital stock in these areas, after depreciation, is either shrinking outright or growing at a very slow pace. In our view, this means that a further sizable drop in spending (i.e. a further slowdown in the growth of the capital stock) would require a sizable negative shock, probably of a financial nature. This could happen, but it is not our expectation.
In addition, we are counting on another push from monetary policy to ease financial conditions via further another round of large-scale asset purchases and/or a more forceful commitment to a long period of near-zero short-term rates. If our growth, employment, and inflation forecasts are on the mark"”and in particular, if the unemployment rate rises back to 10% as we expect"”we are reasonably confident that Fed officials will indeed decide to do significantly more.
So what will happen at Tuesday's FOMC meeting? It's a close call, but we expect an announcement that the proceeds from maturing or prepaid MBS will be reinvested in the bond market (most likely Treasuries). In our view, the gradual tightening of the policy stance that is implied by the current policy of letting the balance sheet shrink is inconsistent with what we expect will be a significant downward revision in the forecasts of the FOMC as well as the Board staff since the last meeting. We have little direct information about any forecast changes, but some insights are available from public documents and speeches by officials and staff at the San Francisco Fed (arguably the most open part of the system in this regard). On May 13"”the last available date before the June 22-23 FOMC meeting"”the SF Fed expected real GDP growth of 3¾% in 2010 on a Q4/Q4 basis. On July 8"”the first available date after the meeting"”the forecast had fallen to 3.1%. And on July 28"”the most recent update"”it had fallen further to 2½%. These numbers require some interpretation since they are affected by a changing picture of H1, and we have no information on any further changes in the wake of the GDP, ISM, and employment data released since July 28. But our interpretation is that the SF Fed has probably revised down its view of H2 growth from about 3½% (clearly above trend) at the June 22-23 FOMC meeting to 2%-2½% (slightly below trend) at the upcoming meeting. If other officials have made similar changes, this would probably be enough to trigger a meaningful shift. And the most obvious meaningful (but not yet radical) shift would be a decision to reinvest MBS paydowns.
However, it is also very possible that the committee will require more time for a shift. One reason to think so was Chairman Bernanke's speech last Tuesday. This was before the employment data, but it was noteworthy that the chairman sounded relatively upbeat, specifically on consumer spending. Undoubtedly, Fed officials are also encouraged by the recent, broad easing in financial conditions. But while this might argue for a decision to do nothing much on Tuesday, such a decision could prove to be a serious mistake, because a significant part of the recent easing in financial conditions is probably due to market expectations of a more expansionary monetary policy. Indeed, if a disappointment on Tuesday results in a significant renewed tightening of conditions, the decision might ultimately hasten the transition to further easing steps . . .
Barclays Capital’s global rates strategy team are rather more cautious — bringing up a potential, and somewhat problematic, unintended consequence of the Fed’s possible QE II :
. . . Recent press articles have highlighted that the Fed may be considering changes to its reinvestment policy as it relates to MBS prepayments and maturing agency debt. Currently, the Fed follows a policy of not reinvesting runoff; this in turn would lead to around USD250- 275bn in shrinkage in the Fed's balance sheet over the next year, thereby also draining cash in the banking system. Press reports indicate that the Fed might reinvest runoff thereby maintaining the current level of monetary stimulus.
We believe that the Fed may certainly allude to the potential for making such changes in the upcoming FOMC statement, contingent on the data continuing to weaken. However, we would be surprised if the Fed actually announces a policy change given the current backdrop.
First, economic conditions, in our opinion, do not warrant additional steps right now. While most economists expect the economy to slow down from the first half, consensus forecasts for real GDP growth in the second half are still around 2.75%. While the unemployment rate at 9.5% is indeed well above the 8.6% level in March 2009 (previous QE announcement), it is expected to decline over the coming quarters and not rise as was the case last year. In addition, Fed's preferred inflation measure "“ core PCE "“ is still running at 1.4% and expectations are for it to decline but remain above deflationary levels. At 1.8%, inflation expectations, as measured by TIPS breakevens, are also much higher than the 1% prevailing last March (Figure 3).
More importantly, if the Fed were to re-invest proceeds in Treasuries, the perception of monetizing government debt may actually result in higher Treasury yields, as inflation expectations could be revised higher. Recall that 10y Treasury yields actually rose by 70bp, led by a 90bp widening in TIPS breakevens, over the three months following the March announcement of $300bn in Treasury purchases.
Back then, with 10y breakevens at 100bp, such a move was palatable. This time around, with 10y breakevens at 180bp and real yields already low at 1.0%, any rise in inflation expectations may actually increase borrowing costs, which would be counter-productive. In our view, if the Fed were to announce more Treasury purchases, long-term yields could rise, and the curve, particularly 5s30, could be steeper than our forecast.
Alternatives
* On the flip slide, investing in the mortgage market is not an easy option either. The Fed has already significantly reduced the float in the mortgage market which has led to persistent fails. Mortgage current coupon yields are already at record lows; refinancing is being held back because of other frictions, which are not addressed using a blunt tool like QE. Besides, in our estimation, a USD250-275bn decrease in the Fed's balance sheet is only worth 5-10bp in Treasury yields, which would hardly affect refinancing incentives meaningfully.
* We believe letting Supplementary Financing bills mature is a cleaner way to prevent a decline in excess reserves. The Treasury has issued USD200bn in 56-day bills and letting them roll over, will largely offset the USD250-275bn in prepays in the Fed's portfolio our mortgage strategist expects over the next year. Were the Fed to do so, front-end yields may decline marginally.
* Cutting the interest paid on reserves to banks (IOER) from its current level of 25bp is also an option. As we have discussed before1, it is unclear on whether lowering shortterm rates further would indeed have the desired effect of increasing lending by banks, and there may be other unintended consequences.
A sentiment also echoed by Marc Ostwald over at Monument Securities:
In terms of the much anticipated FOMC meeting, the question is this: if they do decide to go beyond reinvesting maturing MBS into Treasuries (the latter being nothing more than cosmetic) and add to their QE, is that really a good thing for financial markets? In other words, pumping more money into a liquidity trap will not resolve the US housing market woes, it will not stop the consumer deleveraging, it will not create jobs, but it may speed up the decline of the USD, at a time when more and more countries have already tightened policy significantly (e.g. Australia, Brazil, Chile) or are starting to tighten policy (South Korea, Canada, NZ, Sweden), particularly as any efforts to rein in the US Federal budget deficit, debt mountain would appear to an even more distant prospect.
Meanwhile, Standard Chartered are the only ones that actually seem to be spending time on the question of whether an additional bout of QE will work. And here they’ve gone out on something of a limb. Not only do they think the Fed will do more QE — but they think it definitely works:
- Experience in the US, UK and Japan clearly suggests that QE works
- We expect the Fed to do more quantitative easing by Q1-2011
- The Fed may also promise to keep rates low for longer or until inflation rebounds
With signs of faltering growth in the US, we look at the theoretical backing and empirical evidence for quantitative easing (QE) in the US, UK and Japan.
* We now expect the Federal Reserve to restart QE during the winter. The new US programme is likely to be more weighted towards Treasuries. * The Federal Reserve may take a tiny step in this direction at next week's FOMC meeting by reinvesting the proceeds of maturing bonds rather than allowing the portfolio to shrink.* The UK may do more as well, but only if growth slows more than we expect. Easier monetary policy would help to offset tighter fiscal policy.* In the US and UK, announcements of new QE measures in 2008-09 pushed long yields down and the currencies lower, as expected. Asset prices rose and economic recovery followed.
* In Japan during 2001-04, yields also fell and the economy also recovered, despite simultaneous fiscal tightening. However, opinions differ as to the relative importance of rate promises and QE.
* The US and UK programmes amounted to 12% and 14% of GDP, respectively, spread over a little more than one year. Japan's QE programme starting in 2001 was only 7-8% of GDP spread over three years. The new US programme is again likely to be large.
* The monetarist analysis of QE suggests that it is crucial to keep monetary aggregates growing steadily. Recently, broad money growth has been weak in both the US and UK.
And one of the rare voices of dissent comes from Denmark’s Danske Bank:
In the US the FOMC meeting is the main event next week. Recently, speculation of further easing has intensified. However, we believe that it is premature for the Fed to announce new easing measures at the upcoming meeting. That said, it is quite certain that the assessment of the economic situation will be downgraded following a range of disappointing economic data. Hence, the Fed will continue to communicate that yields will remain exceptionally low for an extended period. It will be interesting to see if Plosser votes against the extended period language again. If not, it will be a dovish sign.
Next week's Fed meeting will be the main event for global bond markets. A more dovish Fed is likely to fundamentally support the current very low level of US 2-year bond yields, but will probably not be able to push them lower. Following the announcement there might even be a minor risk of disappointment given the recent talk about more QE, which we find premature. It will also be important to see if Hoenig dissents again. If not it would be a dovish sign.
So, will the Fed listen to these QE cries?
And forget "disappointment” — will Goldman Sachs et al be mightly ticked-off if they don’t?
The answer to these questions and (no) others to come on Tuesday.
Related links: Quantitative easing: "The greatest monetary non-event” – Pragmatic Capitalism The Fed’s possible baby-step - Money Supply A deflation refresher – FT Alphaville
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