To appreciate just how important the Federal Reserve has been to the U.S. Treasury, consider this simple fact: It alone financed roughly 40 percent of America’s budget deficit last year.
So as Fed officials talk up the possibility of unwinding the central bank’s crisis-era bond holdings later this year, figuring out what will happen when the U.S. loses its biggest source of funding has become a pressing concern.
PG View: This is why I think talk of balance sheet normalization is nothing more than hawkish jawboning, particularly in light of the fact that foreign buyers of Treasuries are pulling back.
Central banks have been the world’s biggest buyers of government bonds, but may soon stop—a tidal shift for global markets. Yet investors can’t agree on what that shift will mean.
Part of the problem is that there is little agreement about how the massive stimulus policies, known as quantitative easing or QE, affected bonds in the first place. That makes it especially hard to assess what happens when the tide changes.
…When the unwinding begins money managers may not be positioned for it, and markets could move swiftly. In the summer of 2013, investors suddenly got spooked about the Federal Reserve withdrawing stimulus, leading to a swift bond sell off that sent yields on the 10-year Treasury up by more than 1 percentage point.
“If it’s unclear what benefits we’ve had in the buying, it’s unclear what will happen in the selling,” said Tim Courtney, chief investment officer at Exencial Wealth Advisors.
PG View: That’s a big question…a $13.3 trillion question (ECB $4.5T, Fed $4.4T, BoJ $4.4T).
European Central Bank President Mario Draghi defended the ECB’s monetary stimulus before Dutch lawmakers on Wednesday in a rare visit to a national parliament, as pressure builds in Northern Europe for a policy change from Frankfurt.
Speaking in the Dutch Lower House, Mr. Draghi argued that the ECB’s large-scale bond purchases and subzero rates have helped support local households and the national budget.
The eurozone’s policymakers have kept their aggressive monetary easing in place ahead of the decisive round of the French presidential election but Mario Draghi hailed improving economic growth.
The European Central Bank’s governing council left its benchmark main refinancing rate at zero and the deposit rate at minus 0.4 per cent. The region’s central bankers will continue to buy €60bn in mostly government bonds under a quantitative easing programme that will run until at least the end of this year.
After heading into the uncharted territory of quantitative easing, the world’s central banks are starting to plan their course through the uncharted waters of quantitative tightening.
How the Federal Reserve, European Central Bank and — eventually — the Bank of Japan handle the transition could make the difference between a global rerun of the 2013 “taper tantrum,” or the near undetectable market response to China’s run-down of U.S. Treasuries in recent years. Combined, the balance sheets of the three now total about $13 trillion, equating to greater than either China’s or the euro region’s economy.
“You know what they say about mountaineering right? The descent is always more dangerous than the ascent,” said Stephen Jen, London-based chief executive of hedge fund Eurizon SLJ Capital Ltd. “Shrinking the balance sheet will be the descent.”
The Federal Reserve is trying to send a message to bond traders: prepare for a reduction in its $4.5 trillion balance sheet. But the traders aren’t buying it yet.
Such a move would most likely cause longer-term borrowing costs to rise because the Fed has been a large buyer of Treasuries and mortgage debt since the 2008 financial crisis. More than $400 billion of its holdings is set to mature next year, so a reduction in the Fed’s reinvestment could potentially depress market values.
…im Bianco, founder and head of Bianco Research in Chicago, said many traders think the Fed won’t make a move until 2020 or beyond.
“It is a mistake to conclude that the current talk means the market is fine with the balance sheet being reduced,” he said.
Most Federal Reserve officials expect the Fed to begin reducing its huge investment holdings later this year, an important step toward ending the Fed’s post-2008 economic stimulus campaign.
Officials discussed the change at the Fed’s most recent meeting in March, according to an official account that the Fed published on Wednesday. No decision was reached about the timing or the details of the move. However, if the economy continues to grow, most officials “judged that a change to the committee’s reinvestment policy would likely be appropriate later this year.”
…Despite the concern of governing council members who have highlighted rising inflation, the ECB’s statement also reaffirmed the bank’s landmark quantitative easing programme, which is due to purchase €780bn worth of bonds this year.
Japan remains definitively stuck, despite a long and aggressive experiment with ultralow rates. A quarter-century after its property bubble burst, a penny-pinching generation has come of age knowing only economic malaise, stagnant wages and deflation—a condition where prices fall instead of rise.
The belief that deflation will continue has become so ingrained it has presented seemingly insurmountable challenges to monetary policy, a lesson for other countries that are traveling a similar path.
“It is hard to change the deflationary mind-set even with radical policies,” says Frederic Neumann, co-head of Asia economics for HSBC. “I would argue Japan will remain in its funk and will remain there for many years.”
PG View: I would suggest Japan may be stuck indefinitely . . .
So, is the Fed moving ever-so-slowly in the opposite direction in recognition of this harsh reality? Or are they just giving themselves a little clearance above the zero-bound so they can do more if it?
The Federal Reserve is stuck in a major pickle — and it’s not about how many times to raise interest rates this year.
The problem stems from years and years of asset purchases — known as quantitative easing. Under the program, the Fed purchased bonds and mortgage-backed securities from banks in the years following the 2008 financial crisis, hoping the companies would use the cash to lend money and stimulate the economy.
PG View: When the Fed ultimately moves to start unwinding its $4.5 trillion balance sheet it could prove incredibly disruptive to markets. And what do you suppose are the odds of another crisis hitting before the balance sheet is fully unwound? I’d say very high as this is likely to be multi-decade process.
The Japanese yen is tumbling after the Bank of Japan kept policy on hold, as virtually all analysts were expecting.
At its Tuesday meeting, the BOJ said it would continue to purchase Japanese government bonds at an annual pace of about 80 trillion yen to maintain a 10-year JGB yield of about 0%.
Interest rates were also left unchanged at -0.1%.
PG View: While this decision was widely anticipated, and Kuroda seemed a little more upbeat on the economy, it seems unlikely the BoJ will take it’s foot off the gas any time soon. This is helping to push the dollar higher and weighing on gold in the process.
Financial Times/Dan McCrum & Thomas Hale/12-19-16
German short-term interest rates dropped to a fresh record low on Monday as traders anticipated the effect of New Year policy changes announced by the European Central Bank this month, at a time when market activity begins to ebb in the final days of the year.
PG View: With the ECB poised to start buying assets yielding less than the deposit rate, easing clearly remains the order of the day. Meanwhile, the Fed is tightening, which is creating ever-widening interest rate differentials with the U.S. This is going to perpetuate the detrimental rise in the dollar, which is going to create growth risks.
08-Dec (FT) — The European Central Bank has decided to scale back its landmark quantitative easing programme from €80bn to €60bn a month, in a move that responds to hawks’ concerns about ultra-loose monetary policy but which could unsettle markets.
The bank confirmed that it would buy €80bn a month of bonds under the current leg of the programme until March, but added that it would reduce the purchase size to €60bn for the nine remaining months of 2017.
06-Dec (ZeroHedge) — Continuing his anti-establishment bent, in his latest letter “Red is the new black”, Bill Gross first exposes the “current global establishment’s (including Trump’s) overall plan” consisting of 8 simple steps to “solve the global debt crisis” (yes, the sarcasm is oozing), at which point he goes on to say that “it pays to not fight the tiger until it becomes obvious that another plan will by necessity replace it” and adds “that time is not now, but growing populism and the increasing ineffectiveness of monetary policy suggest an eventual transition.”
How policymakers plan to solve a long-term global debt crisis:
1. As in Japan, the Eurozone, the U.S., and the UK, central banks bought/buy increasing amounts of government debt (QE), then rebate all interest to their Treasuries and eventually extend bond maturities. Someday they might even “forgive” the debt. Poof! It’s gone.
2. Keep interest rates artificially low to raise asset prices and bail out over-indebted zombie corporations and individuals. Extend and pretend.
3. Talk about “normalization” to maintain as steep a yield curve as possible to help financial institutions with long-term liabilities, but normalize very, very slowly using financial repression.
4. Liberalize accounting rules to make some potentially “bankrupt” insurance companies and pension funds appear solvent. Puerto Rico, anyone?
5. Downgrade or never mention the low interest rate burden on household savers. Suggest it is a problem that eventually will be resolved by the “market”.
6. Begin to emphasize “fiscal” as opposed to “monetary” policy, but never mention Keynes or significant increases in government deficit spending. Use the buzzwords of “infrastructure” spending and “lower taxes”. Everyone wants those potholes fixed, don’t they? Everyone wants lower taxes too!
7. Promote capitalism – even though government controlled, near zero percent interest rates distort markets and ultimately corrupt capitalism as we once understood it. Reintroduce Laffer Curve logic to significantly lower corporate taxes. Foster hope. Discourage acknowledgement of abysmal productivity trends which are a critical test of an economic system’s effectiveness.
8. If you are a policymaker or politician, plan to eventually retire from the Fed/Congress/ Executive Wing and claim it’ll be up to the Millennials now. If you are an active as opposed to passive investment manager, fight the developing trend of low fee ETFs and index funds. But expect to retire with a nest egg.
That’s the plan dear reader, and President-elect Trump’s policies fit neatly into numbers 6, 7 and 8. There’s no doubt that many aspects of Trump’s agenda are good for stocks and bad for bonds near term – tax cuts, deregulation, fiscal stimulus, etc. But longer term, investors must consider the negatives of Trump’s anti-globalization ideas which may restrict trade and negatively affect corporate profits.
Full Investment Outlook from Bill Gross click here.
29-Nov (Reuters) — The European Central Bank is ready to temporarily step up purchases of Italian government bonds if the result of a crucial referendum on Sunday sharply drives up borrowing costs for the euro zone’s largest debtor, central bank sources told Reuters.
…The ECB could use its 80-billion-euro ($84.8 billion) monthly bond-buying program to counter any immediate, further spike in bond yields after the vote, smoothing market moves and supporting bonds, according to four euro zone central bank sources who asked not to be named.
17-Nov (WSJ) — The Bank of Japan on Thursday offered to buy an unlimited amount of Japanese government bonds at fixed rates for the first time since the introduction of a new policy framework—a sign of its concerns over recent rises in yields.
The move is the first clear sign from the central bank that it intends to take action to keep a lid on rising yields, and took market participants by surprise.
“I thought there was still a lot more room left” before the BOJ took action, said Masahiro Ichikawa, senior strategist at Sumitomo Mitsui Asset Management.
The BOJ’s move followed a sharp rise in government bond yields globally, sparked by expectations that the presidency of Donald Trump would lift inflation and growth. Japanese government bond yields have risen as well, but not as sharply. The 10-year yield rose to its highest level since March on Wednesday.
07-Nov (Reuters) — The European Central Bank is not considering reducing its bond-buying program known as Quantitative Easing, and is looking instead at how far to extend it after the current March 2017 deadline, the Bank of Italy said on Monday.
Luigi Signorini, a member of the Italian central bank’s executive board, was asked during testimony to parliament whether the ECB was looking at how to taper QE.
“There is no prospect of this,” Signorini replied. “The question is how much to extend the limits that were given.”
Patrick Massett, Matthew McConaughey, Michael Nozik, Teddy Schwarzman, John Zinman.
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22-Sep (FT) — Officials at the European Central Bank fear they could be hemmed in by legal action as they look for ways to extend their quantitative easing programme to help fuel the eurozone’s fragile recovery.
The €80bn-a-month bond buying plan is already the subject of a legal challenge and officials fear that its problems in court will increase if the ECB relaxes the conditions of the scheme — a move staff are considering.
Peter Gauweiler, a conservative German politician who has sued the ECB in the past, told the Financial Times that changes to QE would “increase the chances of success” of a case he and others are trying to bring against the asset purchase programme.
Committees of eurozone central bankers this month started work on ways to expand the pool of assets eligible for QE so as to overcome shortages of the safest government debt, such as German Bunds. Their task is particularly important if — as the markets expect — the ECB extends QE beyond the scheduled end date of March 2017.
Mr Gauweiler believes that QE “already violates rules on the prohibition of monetary financing [of eurozone governments] by the ECB” — even before any alteration of its conditions. He said that softening the rules could redistribute the risk of a member state default, “which is clearly incompatible with European law”.
21-Sep (Bloomberg) — The yen rose against the dollar, reversing the slide that was the initial reaction to the Bank of Japan saying it would adopt a more flexible approach to expanding stimulus.
The Japanese currency’s rebound to a more than three-week high suggests investors are both skeptical officials will achieve their long-term policy goal of boosting inflation and that they’re already shifting their focus to the Federal Reserve’s policy decision later today.
The yen earlier dropped more than 1 percent after BOJ Governor Haruhiko Kuroda and his board said the central bank would move away from a rigid target for expanding the money supply, while seeking to control bond yields across different maturities. They pledged to expand the monetary base until inflation is stable above the authority’s 2 percent target — committing to an overshoot of consumer-price gains.
“We can be more sure that the BOJ wants to reach inflation, but we can be less sure that they are willing, or able, to take the necessary steps,” said Ulrich Leuchtmann, head of currency strategy at Commerzbank AG in Frankfurt. “I would not be surprised if dollar-yen would come down again in the coming days.”
The yen climbed 0.2 percent to 101.47 per dollar as of 7 a.m. in New York, after earlier sliding as much as 1.1 percent to 102.79. It touched the strongest level since Aug. 26.
21-Sep (FT) — The Bank of Japan has launched a new kind of monetary easing as it set a cap on 10-year bond yields and vowed to overshoot its 2 per cent inflation target on purpose.
Its decision demonstrates that even eight years after the global financial crisis, central bankers are still willing to experiment with new monetary policy tools as they struggle to escape from low inflation around the world.
The move marks another effort by Haruhiko Kuroda, BoJ governor, to surprise market expectations by expanding his monetary policy toolkit to signal his determination that Japan escape its decades of on-and-off deflation.
But the question for Mr Kuroda is whether three-and-a-half years of slow progress on prices have damaged the BoJ’s credibility too much for promises of higher inflation to be taken seriously by the public.
…The BoJ kept interest rates on hold at minus 0.1 per cent — describing further rate cuts as a “possible option for additional easing” — but announced a new framework with two main elements.
The first is a pledge to cap 10-year government bond yields at zero per cent. In essence, that means the BoJ is promising to buy any bonds offered for sale at that price.
Second, the BoJ has pledged to continue buying assets until inflation “exceeds the price stability target of 2 per cent and stays above the target in a stable manner”.
16-Sep (AFR) — Forget the Fed. All eyes are now firmly fixed on next week’s Bank of Japan (BoJ) meeting for clues as to where global bond and equity markets are headed next.
A global bond sell-off has sent yields on US, Japanese, German and Australian long-term bonds surging this month, after they fell to historic lows earlier in the year. (Yields rise as bond prices fall).
Investors are worried that central banks in Japan and Europe may decide to reduce, or temper their extreme monetary stimulus policies amid mounting evidence that they have failed to bolster either growth or inflation.
Investors are particularly focussed on the Bank of Japan, which for the past 3 1/2 years has been engaged in the world’s most audacious experiment in monetary stimulus experiment – including massive bond purchases and negative interest rates.
But there are growing questions about whether the benefits of these policies outweigh the costs.
09-Sep (Reuters) — The Bank of Japan is studying several options to steepen the bond yield curve, say sources familiar with its thinking, as authorities desperately seek out policy tools to revive an economy that has failed to emerge from stagnation despite years of massive stimulus.
BOJ officials have become increasingly wary of the costs of a flattening yield curve, such as hurting bank profits, especially as its controversial decision to adopt negative rates in January has made matters worse.
Bank bureaucrats are brain-storming ways to cut short- to medium-term bond yields, which affect corporate borrowing costs the most, while pushing up super-long yields from undesirably low levels, the sources said on condition of anonymity.
The options might be debated at this month’s rate review as part of measures to fine-tune its massive stimulus programme, they said.
…The BOJ could technically buy foreign bonds from domestic financial institutions and describe the step as aimed at supplying yen liquidity, not weakening the yen. But the amount of foreign bonds held by domestic banks is probably too small to have a sizable impact on the economy, the sources said.
“It would be hard to justify buying foreign bonds when there are many domestic assets still available for the BOJ to buy,” said one of the sources.