In light of recent events, and considering a Sunday morning tweet from President Trump, I wanted to take a few minutes to expand a bit on two related issues I’ve discussed previously at some length, but which are now more relevant than ever.
I’ll just dive right in, and in the interest of clarity, I’ll break it up into two sections.
I: ‘QE-Lite’ Cometh
On Thursday, in a post for this platform, I brought you the “real takeaway” from the September Fed meeting. I won’t recount the entire backstory here as you can read it for yourself, but suffice to say an acute squeeze in funding markets on Monday and Tuesday raised the stakes for Jerome Powell at the last minute, and during his post-meeting press conference, the embattled Fed chair arguably didn’t come across as sufficiently concerned.
In brief, a series of idiosyncratic factors including a corporate tax deadline, coupon settlements and the previous week’s bond rout, conspired with structural/legacy issues including ambiguity around what counts as “ample” when it comes to reserves, the ongoing deluge of supply from Treasury to fund the deficit and an onerous regulatory regime, to create chaos in short-term money markets. Ultimately, the effective Fed funds rate was pulled through the upper-end of the target range which, in layman’s terms, meant the Fed had lost control of rates.
So, the New York Fed stepped in with overnight repos on Tuesday, Wednesday, Thursday and Friday in an effort to restore order. Thursday and Friday’s operations were oversubscribed which, along with sliding swap spreads and lackluster four- and eight-week bill sales, suggested markets were still palpably concerned, even as the affected rates showed signs of normalizing.
The squeeze grabbed all manner of headlines on Monday and Tuesday, and compelled some banks to suggest the Fed might announce balance sheet expansion and/or a standing repo facility on Wednesday. Instead, the FOMC tweaked IOER again and promised to stay in the market with “as needed” liquidity injections. During the press conference, Powell came across as somewhat ambivalent about the situation when pressed by CNBC’s Steve Liesman, but he did eventually get around to acknowledging that the Fed would likely have to begin “organically” growing the balance sheet sooner than expected.
Again, I went over all of that in the linked post above, and the overarching point I tried to drive home was that when balance sheet expansion starts, it won’t be “QE”, per se, something that will almost surely be lost on some market participants.
The Fed on Friday announced that daily overnight repos would continue through October 10. They released a schedule of the operations which includes three 14-day term ops on September 24, 26 and 27.
That was all at once a tacit admission that in the absence of a schedule or term repos, funding stress would have likely persisted amid expected month- and quarter-end pressures, and a bid to show that the Fed can reestablish control over the very front-end whenever it so chooses. These operations will be watched closely over the next two weeks, but they should be enough to take the risk of another acute episode off the table.
However, now the Fed will have to either roll the term repos when they mature in mid-October, or else have already announced the resumption of balance sheet expansion, if they want to avoid spooking the market anew. “The Fed should announce they are starting outright purchases no later than the October FOMC meeting,” BofA wrote, in a Friday note, adding that “we believe the market would be very disappointed and repo vol would increase if term repos or outright purchases do not continue after mid-October.”
In short, “QE-lite” (as “organic” balance sheet growth to relieve reserve scarcity has been dubbed) is a foregone conclusion, and it will start next month barring an inexplicable decision by the Powell Fed to willingly tempt fate by irritating the market.
You should be prepared to hear Fed officials lay the groundwork for this over the next several weeks. BofA’s estimates (and desks differ on this, but the passive depletion of reserves suggests the Fed will need to grow the balance sheet by at least $100 billion annually) call for “an initial $250 billion in purchases” in order to get back to an “abundant” level of reserves (that includes $100 billion to bring us back from the precipice of the upward sloping portion of the demand curve, and another $150 billion to account for the change in other liabilities). After that, the bank sees the balance sheet growing at $150 billion annually.
Again, this is now all but a foregone conclusion in light of last week’s events, and investors should be prepared to read all manner of “hot” takes on the subject as officials will invariably be compelled to discuss it ahead of the October Fed meeting. As noted in my Thursday post here, you should not mistake this for “QE”. Indeed, Bill Dudley emphasized as much in an Op-Ed for Bloomberg out Friday. To wit:
There probably wasn’t sufficient time to prepare a detailed proposal this week, given that the pressure in the repo market wasn’t evident until Monday. And officials will have to communicate carefully, so the move won’t be confused with quantitative easing. Although the Fed’s balance sheet grows in both cases, the intent is completely different. To signal this, the Fed could focus on adding shorter-term obligations such as Treasury bills, as opposed to the longer-duration assets typically involved in QE.
II: ‘The most important chart in the world’
On Sunday morning, President Trump lashed out at Jerome Powell on Twitter as he’s wont to do. His latest monetary policy criticism included a quote, which seems to have been pulled from somewhere, but because the President didn’t indicate where, I’m unable to link (I’m not being sarcastic there at all – he put it in quotes, but there was no attribution):
Go across the world and you’ll see either very low interest rates, or negative rates. The President wants to be competitive with these other countries on this, but I don’t think he’ll fire Jay Powell.
Shortly thereafter, Kevin Muir (formerly head of equity derivatives at RBC Dominion and currently head of research of global and domestic investment products at East West Investment Management) referenced the President’s tweet, quipping that “nobody [should] show [Trump] what I think is the most important chart in the world.”
The chart Kevin was referring to is from Jim Bianco, and it shows the number of countries with policy rates lower than the US (incidentally, I attempted to recreate this myself using the same IMF database, but it’s very large, and after two consecutive Excel crashes, I just decided to use Jim’s):
That bottom pane is pretty remarkable, and it gets us back to a point I’ve pounded the table on previously – namely that without aggressive rate cuts to “catch up”, the Fed risks importing disinflation.
For months, the go-to explanation for why markets were pricing in more easing than the Fed was willing to explicitly countenance revolved around the idea that the markets are “sniffing out” a recession. But, it could be that markets have decided that with the rest of the world cutting rates and with the US economy still outperforming, the monetary policy divergence on display in the visual above all but guarantees the US will import disinflation at a time when the Fed is already struggling to hit its mandate. Higher rates, a better economy, the dollar’s reserve status and a world in turmoil is a recipe for a stronger dollar, even as America’s fiscal trajectory continues to deteriorate.
That, Deutsche Bank previously argued, is why the market has been so persistent in pricing in a fairly aggressive series of Fed cuts, not necessarily because most people see the US careening into a deep recession. If the Fed doesn’t cut aggressively now, they are chancing a scenario where a persistently strong greenback continues to imperil the inflation mandate and begins to serve as a drag on corporate profitability. Eventually, they’d have to catch up by slashing rates in a panic, which could spook markets.
Taken together, what the two sections above suggest, is that by the middle of next year, the Fed is going to be growing the balance sheet (albeit “organically” to ensure reserves remain ample as opposed to aggressively in order to “pump up” reserves) and engaged in more begrudging rate cuts, the ambiguity in the latest dot plot notwithstanding.
There doesn’t seem to be any way out of this, barring a sudden inflection (for the better) in global growth which takes some of the pressure off the dollar (thereby alleviating the need for the Fed to cut rates to avoid importing disinflation), or some kind of structural shift in both the regulatory regime and US debt dynamics that alters the equation which now compels the Fed to start growing the balance sheet anew.
Ultimately, the future is shaping up to look a lot like the recent past: Balance sheet expansion and the possibility of rate cuts until we approach the zero lower bound.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.