THE MECHANISM BEHIND QUANTITATIVE EASING &THE IMPACT OF TAPERING
Over the past few months one of the most popular topics generally has been related to whether the FED will taper its asset purchases. Now that we are almost past the recovery phase and about to enter the economic mid-cycle expansionary phase as inflation is far about target (>4% compared to 2%) and GDP is far above trend (2021 Estimate of ~6-8% vs potential GDP of 1.9%) it is clear that the current accommodative monetary stance may have higher risks than returns in the medium run.
This idea will go into detail and I will attempt to answer the question of how does QE and FED balance sheet tapering work and what are the implications for broad assets prices and your investment portfolio?
1. Firstly, what is the mechanism behind QE, tapering, and how does it affect your portfolio?
The FED has 3 key methods through which it conducts its monetary policy: 1) Discount Rates 2) Required Reserves 3) Open Market Operations (OMOs). Within OMOs fall any operations that expand, stabilize or unwind assets of the FEDs balance sheet (here too derivative products such as dollar swaps can be included). Moreover, in even broader terms, credit creation can be directed at consumer credit, commercial and industrial business loans and financial products. This is just an attempt to illustrate how it all works.
It's arguable that the more important side of QE is the Mortgage-backed securities (your housing mortgages pooled together in one security and sold to investors, the FED etc) purchases, which is more directly aimed at particular market segment. The enormous question is why are FEDs MBS purchases perhaps the most influential OMO tool? The MBS market is fairly complex, but one potential explanation (not mine) is that as the FED is the most secure and largest buyer of MBS, for the rest of the investors the portfolio risks (ex Value-at-Risk) fall substantially for this part of their portfolio allowing them to take a more risk-on approach for other asset classes (equities). Additionally, my guess is given that MBS purchases imply a steadier equity value for US home owners for whom the majority of their equity is tied to the value of their houses, as credit becomes more easily available to new home buyers, existing home buyers can also take on a more risk-on approach to investing into other assets. This is observed from the FEDS MBS balance sheet operations in 2013 and 2018 and 10 year curve which reflects growth, the MBS QE side is most directly related to changes in the 10 year. Higher housing demand can perhaps imply higher growth due to the Real Estate component of GDP (ex China), although the net-benefit is debatable. The relationship between asset purchases, housing prices and rents in the past 10 years has been fairly complex (snipboard.io/LHglRP.jpg), since it takes time for the newly created money supply to show in the national Case-Shiller housing prices, causing an instable lead-lag relationship.
Moreover, the two tapering Operation twists in 2011 and 2014 (Operation twist is a yield curve control measure, where the FED sells short-term treasuries and buys longer term treasuries, with the aim of flattening the yield curve), caused drops in the 10 year yields, leading to even more elevated stock prices (particularly high duration growth stocks). In essence, the FED over the past decade, has actively attempted to suppress yields whose by-product lead to even more elevated P/E ratios (multpl.com/s-p-500-pe-ratio). How? All assets are priced based on their cashflow(profit) growth and the riskiness of it. In the component of riskiness, are nominal interest rates, hence if nominal interest rates fall => required return falls => for the same earnings growth you get a higher P/E multiple. Running a simple linear regression on SPX P/E multiples and 10 year FED >10 year asset purchases and MBS for the past 5 years, the beta coefficients of both purchasing programs are 0.385 and 0.4, however only the 10 year asset purchases beta is significant (t-stat of 2.4, obviously not robust, many further iid checks are necessary). This means that if the FED does taper and is not forced to do a third Operation Twist, P/E ratios should remain relatively stable in 2021 (snipboard.io/TAZWzx.jpg), although this is also assumes no major fiscal changes (capital gains/corporate tax related) and no large demand shocks.
2. Alright, then what gives, based on what outcomes do the FED members vote whether to taper and/or do other monetary policy adjustments?
It comes to two simply stated mandates, yet their relationship is quite complex and it is a trade-off between 1) Maximum employment (Unemployment rate below <5% of the long-term rate) and 2) Price stability(inflation within the target range 1-5 to 2.5%). The FED has recently been focused primarily on Maximum employment, however it is clear that there are many structural issues in the labor market that have slowed down its recovery.
It is arguable that this has caused even greater pressures on wages.
With both wage and commodity input prices rising, business are forced with a choice of whether to pass through costs. If they do, higher prices imply lower sales volumes impacting their market share and if they don't, their profit margins are squeezed. However, neither seems to be happening on a large scale yet as the SPX profit margins are at an all-time high (snipboard.io/O6ukvH.jpg), although the SPX is heavily tech sector skewed, whose margins are not as affected by commodity prices. Eventually, business will pass through costs, if the company costs are persistent (such as wages), and profit margins will readjust lower. The old inflation paradigm was, shelter CPI growing above the 2% target at 3-3.5%, while the rest of consumer goods and services growing below 2% allowing for the overall core inflation to be within the target range. However, wages are growing above trend, shelter prices are picking is above target, and consumer credit is starting to grow again (snipboard.io/0kxZ1N.jpg). The longer the FED delays cooling down the market, the higher the risks of persistent inflation. The global supply chain bottlenecks are just the icing on the cake. However, if the FED does taper, that will provide quite an immediate slowdown in PMIs.
Additionally, if the FED tapers today, that would imply potential dollar shortage accompanied with the current slowdown in China, which can be a serious threat to EM, as it would be harder for companies to satisfy their dollar denominated debt obligations. The dollar rise from rising hawking expectations from the FED, are partially off-set by the quicker hawkish schedules from other central banks, however the dollar should still gain, especially if the slowdown in China persists and other EM countries continue to struggle dealing with Covid.
4. Interestingly, given zero interest rates and vast increase in money supply, how has inflation been very muted post 2009 until the pandemic occurred?
Having zero interest rates, accompanied by expansion in financial asset credit, implies that cash needs of households and businesses are satisfied. Any major credit risks are further alleviated as the excess liquidity decreases roll-over risks for companies, allowing them to borrow at increasingly low debt costs. This paradigm reinforces competition, which reinforces innovation, which has been a greater drag on inflation than excess liquidity has been an inflation push. This allowed for muted inflation in goods and services, even further placing pressure on the yield curve level, driving asset prices even higher. The owners of financial assets have been the greatest beneficiaries due to the high real yields. This has also meant a higher income inequality, which a real systematic risk on a going forward basis.
The difference relative to post 2008 and the post-pandemic policies, which also included expansion in credit to households (government checks) and credit to small business on a far greater scale(Bush admin only gave 300$), which were principally financed by the Fed as the major buyer of Treasuries (snipboard.io/09wG3M.jpg). The Fed now owns >20% of the entire treasury supply, however still less relatively to most other central banks (snipboard.io/IVSwEK.jpg). Hence, the major problem that the FED is in, is how to tackle income inequality, as the current fiscal policies are directly related to inflationary pressures (government gives people cash checks, people spend it on consumer goods, prices rise). Democrats policies with are aimed at dealing with inequality, may have major inflationary expectations, which if they get out of control, may force the Feds hand, in which case the fed would have to raise interest rates or perform a major balance sheet unwinding, causing a major short-term downturn and possibly a recession. For now this is the unlikely scenario, and chances are that the stagflationary scenario in the medium term is more likely, however this issue will be reserved for some other post.
5. What returns to expect for the rest of 2021 and going forward into 2022?
To summarize this idea, the is a chart showing the SPX/FED assets ratio, summarizes the reliance of equity prices to QE where the SPX would be nearly flat if it weren't for QE, as the rises in QE purchases are almost tad-for-tad followed by rising equity prices.
This is why before making any investments, the most fundamental consideration to make should include how will the FED guide asset prices forward. QE used to be aimed at elevating financial stresses as central banks bought toxic assets so that banks capital ratios improved, however because of lack of flexibility on interest rates as they were nearly pegged to the zero-lower bound post 2008 and the far greater sensibility to interest rate changes as leverage rose (both private and public), QE or asset purchasing programs became the primary monetary policy tool used by developed regions central banks. It's clear that QE can be considered as an asset price guiding program. The current consensus at the FED is that they will adjust asset purchases (taper) downwards by year end which should last until the middle of 2022, when they can readjust policy and start expanding asset purchases again. Currently I would not rely on any guidance by the FED and rate hike dot plot expectations are pointless given the current volatile environment. Overall, if the FED decides to taper today, or in the upcoming months expect a choppy first half of 2022, followed by a drift higher in the second half with high conditionality on inflation being muted and lower probability of rate hikes. One thing is certain, which is do not expect the same 2020, 2021 returns in 2022. If the FED does not taper today expect a short-lived rally, and another drop going into the year end, otherwise if the FED does taper today last weeks dip should extend which should be followed by a potential year end rally.
On the fiscal side risks remain high of policy adjustments that may target investment income which may cause the reward from investing to drop while risks to rise, in addition to other highly inflationary fiscal policies such as the current infrastructure plan. If you are highly risk-averse and are looking to buy the dip, I would recommend caution, and perhaps wait (if the FED does taper) until May to invest and do consider whether 6%-10% potential returns in 2022 and the potential forward market risks are aligned with your risk profile.
There are many other factors to consider such as negative real yields and the factors that can cause a stagflationary environment going forward which I will analyze in some other ideas!
Thanks for taking the time to read this idea! Any comments, questions and discussions are welcome!
-Step_ahead_ofthemarket
________________________________________________________________________________________
>>I do not share my ideas for the likes or the views. This channel is only dedicated to well-informed research and other noteworthy and interesting market stories.>>
However, if you'd like to support me and get informed in the greatest of details, every thumbs up and follow is greatly appreciated!
Disclosure: This is just an opinion, you decide what to do with your own money. For any further references or use of my content- contact me through any of my social media channels.
This idea will go into detail and I will attempt to answer the question of how does QE and FED balance sheet tapering work and what are the implications for broad assets prices and your investment portfolio?
1. Firstly, what is the mechanism behind QE, tapering, and how does it affect your portfolio?
The FED has 3 key methods through which it conducts its monetary policy: 1) Discount Rates 2) Required Reserves 3) Open Market Operations (OMOs). Within OMOs fall any operations that expand, stabilize or unwind assets of the FEDs balance sheet (here too derivative products such as dollar swaps can be included). Moreover, in even broader terms, credit creation can be directed at consumer credit, commercial and industrial business loans and financial products. This is just an attempt to illustrate how it all works.
It's arguable that the more important side of QE is the Mortgage-backed securities (your housing mortgages pooled together in one security and sold to investors, the FED etc) purchases, which is more directly aimed at particular market segment. The enormous question is why are FEDs MBS purchases perhaps the most influential OMO tool? The MBS market is fairly complex, but one potential explanation (not mine) is that as the FED is the most secure and largest buyer of MBS, for the rest of the investors the portfolio risks (ex Value-at-Risk) fall substantially for this part of their portfolio allowing them to take a more risk-on approach for other asset classes (equities). Additionally, my guess is given that MBS purchases imply a steadier equity value for US home owners for whom the majority of their equity is tied to the value of their houses, as credit becomes more easily available to new home buyers, existing home buyers can also take on a more risk-on approach to investing into other assets. This is observed from the FEDS MBS balance sheet operations in 2013 and 2018 and 10 year curve which reflects growth, the MBS QE side is most directly related to changes in the 10 year. Higher housing demand can perhaps imply higher growth due to the Real Estate component of GDP (ex China), although the net-benefit is debatable. The relationship between asset purchases, housing prices and rents in the past 10 years has been fairly complex (snipboard.io/LHglRP.jpg), since it takes time for the newly created money supply to show in the national Case-Shiller housing prices, causing an instable lead-lag relationship.
Moreover, the two tapering Operation twists in 2011 and 2014 (Operation twist is a yield curve control measure, where the FED sells short-term treasuries and buys longer term treasuries, with the aim of flattening the yield curve), caused drops in the 10 year yields, leading to even more elevated stock prices (particularly high duration growth stocks). In essence, the FED over the past decade, has actively attempted to suppress yields whose by-product lead to even more elevated P/E ratios (multpl.com/s-p-500-pe-ratio). How? All assets are priced based on their cashflow(profit) growth and the riskiness of it. In the component of riskiness, are nominal interest rates, hence if nominal interest rates fall => required return falls => for the same earnings growth you get a higher P/E multiple. Running a simple linear regression on SPX P/E multiples and 10 year FED >10 year asset purchases and MBS for the past 5 years, the beta coefficients of both purchasing programs are 0.385 and 0.4, however only the 10 year asset purchases beta is significant (t-stat of 2.4, obviously not robust, many further iid checks are necessary). This means that if the FED does taper and is not forced to do a third Operation Twist, P/E ratios should remain relatively stable in 2021 (snipboard.io/TAZWzx.jpg), although this is also assumes no major fiscal changes (capital gains/corporate tax related) and no large demand shocks.
2. Alright, then what gives, based on what outcomes do the FED members vote whether to taper and/or do other monetary policy adjustments?
It comes to two simply stated mandates, yet their relationship is quite complex and it is a trade-off between 1) Maximum employment (Unemployment rate below <5% of the long-term rate) and 2) Price stability(inflation within the target range 1-5 to 2.5%). The FED has recently been focused primarily on Maximum employment, however it is clear that there are many structural issues in the labor market that have slowed down its recovery.
It is arguable that this has caused even greater pressures on wages.
With both wage and commodity input prices rising, business are forced with a choice of whether to pass through costs. If they do, higher prices imply lower sales volumes impacting their market share and if they don't, their profit margins are squeezed. However, neither seems to be happening on a large scale yet as the SPX profit margins are at an all-time high (snipboard.io/O6ukvH.jpg), although the SPX is heavily tech sector skewed, whose margins are not as affected by commodity prices. Eventually, business will pass through costs, if the company costs are persistent (such as wages), and profit margins will readjust lower. The old inflation paradigm was, shelter CPI growing above the 2% target at 3-3.5%, while the rest of consumer goods and services growing below 2% allowing for the overall core inflation to be within the target range. However, wages are growing above trend, shelter prices are picking is above target, and consumer credit is starting to grow again (snipboard.io/0kxZ1N.jpg). The longer the FED delays cooling down the market, the higher the risks of persistent inflation. The global supply chain bottlenecks are just the icing on the cake. However, if the FED does taper, that will provide quite an immediate slowdown in PMIs.
Additionally, if the FED tapers today, that would imply potential dollar shortage accompanied with the current slowdown in China, which can be a serious threat to EM, as it would be harder for companies to satisfy their dollar denominated debt obligations. The dollar rise from rising hawking expectations from the FED, are partially off-set by the quicker hawkish schedules from other central banks, however the dollar should still gain, especially if the slowdown in China persists and other EM countries continue to struggle dealing with Covid.
4. Interestingly, given zero interest rates and vast increase in money supply, how has inflation been very muted post 2009 until the pandemic occurred?
Having zero interest rates, accompanied by expansion in financial asset credit, implies that cash needs of households and businesses are satisfied. Any major credit risks are further alleviated as the excess liquidity decreases roll-over risks for companies, allowing them to borrow at increasingly low debt costs. This paradigm reinforces competition, which reinforces innovation, which has been a greater drag on inflation than excess liquidity has been an inflation push. This allowed for muted inflation in goods and services, even further placing pressure on the yield curve level, driving asset prices even higher. The owners of financial assets have been the greatest beneficiaries due to the high real yields. This has also meant a higher income inequality, which a real systematic risk on a going forward basis.
The difference relative to post 2008 and the post-pandemic policies, which also included expansion in credit to households (government checks) and credit to small business on a far greater scale(Bush admin only gave 300$), which were principally financed by the Fed as the major buyer of Treasuries (snipboard.io/09wG3M.jpg). The Fed now owns >20% of the entire treasury supply, however still less relatively to most other central banks (snipboard.io/IVSwEK.jpg). Hence, the major problem that the FED is in, is how to tackle income inequality, as the current fiscal policies are directly related to inflationary pressures (government gives people cash checks, people spend it on consumer goods, prices rise). Democrats policies with are aimed at dealing with inequality, may have major inflationary expectations, which if they get out of control, may force the Feds hand, in which case the fed would have to raise interest rates or perform a major balance sheet unwinding, causing a major short-term downturn and possibly a recession. For now this is the unlikely scenario, and chances are that the stagflationary scenario in the medium term is more likely, however this issue will be reserved for some other post.
5. What returns to expect for the rest of 2021 and going forward into 2022?
To summarize this idea, the is a chart showing the SPX/FED assets ratio, summarizes the reliance of equity prices to QE where the SPX would be nearly flat if it weren't for QE, as the rises in QE purchases are almost tad-for-tad followed by rising equity prices.
This is why before making any investments, the most fundamental consideration to make should include how will the FED guide asset prices forward. QE used to be aimed at elevating financial stresses as central banks bought toxic assets so that banks capital ratios improved, however because of lack of flexibility on interest rates as they were nearly pegged to the zero-lower bound post 2008 and the far greater sensibility to interest rate changes as leverage rose (both private and public), QE or asset purchasing programs became the primary monetary policy tool used by developed regions central banks. It's clear that QE can be considered as an asset price guiding program. The current consensus at the FED is that they will adjust asset purchases (taper) downwards by year end which should last until the middle of 2022, when they can readjust policy and start expanding asset purchases again. Currently I would not rely on any guidance by the FED and rate hike dot plot expectations are pointless given the current volatile environment. Overall, if the FED decides to taper today, or in the upcoming months expect a choppy first half of 2022, followed by a drift higher in the second half with high conditionality on inflation being muted and lower probability of rate hikes. One thing is certain, which is do not expect the same 2020, 2021 returns in 2022. If the FED does not taper today expect a short-lived rally, and another drop going into the year end, otherwise if the FED does taper today last weeks dip should extend which should be followed by a potential year end rally.
On the fiscal side risks remain high of policy adjustments that may target investment income which may cause the reward from investing to drop while risks to rise, in addition to other highly inflationary fiscal policies such as the current infrastructure plan. If you are highly risk-averse and are looking to buy the dip, I would recommend caution, and perhaps wait (if the FED does taper) until May to invest and do consider whether 6%-10% potential returns in 2022 and the potential forward market risks are aligned with your risk profile.
There are many other factors to consider such as negative real yields and the factors that can cause a stagflationary environment going forward which I will analyze in some other ideas!
Thanks for taking the time to read this idea! Any comments, questions and discussions are welcome!
-Step_ahead_ofthemarket
________________________________________________________________________________________
>>I do not share my ideas for the likes or the views. This channel is only dedicated to well-informed research and other noteworthy and interesting market stories.>>
However, if you'd like to support me and get informed in the greatest of details, every thumbs up and follow is greatly appreciated!
Disclosure: This is just an opinion, you decide what to do with your own money. For any further references or use of my content- contact me through any of my social media channels.
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