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Industry Voices

Commentary: The great QE unwind is coming

After ending quantitative easing in 2014, the Federal Reserve now plans to begin shrinking its balance sheet over the next several years by tapering the reinvestment of its Treasury and mortgage-backed security holdings. During the same period, U.S. deficits are projected to grow substantially — notwithstanding the possible enactment of any of President Donald Trump's major proposed legislative initiatives, which would likely cause deficits to swell even further.

Increasing U.S. deficits will require the Treasury to ramp up bond issuance. As a greater risk premium will be required to attract new buyers to absorb both the U.S. primary deficit and the Fed's reduction in its holdings, the U.S. yield curve is likely to steepen. Price concessions into Treasury auctions will likely increase as well.

The European Central Bank, for its part, is increasingly expected to begin winding down its QE program in 2018. This is likely to bring steeper European yield curves, putting additional pressure on the U.S. curve to steepen further.

By communicating the end of QE in advance and increasing the rate of reduction gradually, the Fed hopes to avoid the "taper tantrum" that roiled markets from 2013 until early 2016, when U.S. equities, and global assets more generally, were subject to periodic risk-off episodes.

The aim of QE was to push flows into more productive investments — not just financial assets. Unfortunately, evidence for increased economic activity from QE is relatively weak.

Yet QE did have an impact. It artificially flattened yield curves, weakened the country's currency, allowed poorly performing companies to roll over debt and inflated asset prices.

By depressing yields on government securities, QE encouraged yield-seeking behavior. Many analysts note that the growth of central bank balance sheets has been eerily correlated with the increased value of global risk assets and U.S. equities.

In June, the Federal Open Market Committee raised interest rates by 25 basis points for the third consecutive quarter. The Fed did so, based on internal Phillips curve models, which predict that low levels of unemployment lead to increasing inflation. As the Fed starts to implement its balance sheet runoff, it may find it increasingly difficult to maintain its rate hiking cycle.

Balance sheet reduction is likely to commence in the fourth quarter for both U.S. Treasury holdings and mortgage-backed securities. The combined maximum rate of reduction is $10 billion a month but rising incrementally to a maximum $50 billion a month by the fourth quarter of 2018.

While the Fed has previously tapered its purchases, and in fact ended purchases for brief periods twice, neither it nor any other major central bank that has engaged in QE has actually tried to shrink its balance sheet thereafter. What's odd is that the Fed and other central banks have made claims about the efficacy of QE, but when the policy goes into reverse, they seem to think there won't be any meaningful effect.

The Fed says it hopes the process will "run quietly in the background" and not amount to policy tightening. We shall see. I believe that Fed balance sheet shrinkage could have substantially greater effects on both bond markets and financial markets, generally, than conventional interest rate increases.

Since QE purchases ended, the Fed has continued to reinvest the coupon and principal payments of both Treasuries and MBS holdings. Starting in October, the Fed will likely reduce reinvestments of purchases of Treasuries by $6 billion a month, while reducing MBS reinvestments by $4 billion a month.

In 2018 the Fed will allow up to $180 billion of Treasuries and up to $120 billion of MBS to run off. Thereafter, it will allow up to $360 billion of Treasuries and up to $240 billion of MBS runoff.

This is likely to come against a backdrop of a rising U.S. deficit, which is projected to rise to more than $1 trillion by 2022 (vs. $500 billion in 2015). These projections, moreover, do not include the possible enactment of any of President Trump's likely deficit-raising policies on fiscal spending, defense increases, infrastructure spending or tax cuts.

In the Treasury market, increased supply at auctions will grow steadily throughout 2018, which will likely result in significant yield curve steepening. Rather than being used as a liquidity point for investors to buy large quantities of bonds, Treasury auctions will be more difficult to digest.

It is therefore likely that as net new issuance increases (accounting for the reduction in Fed purchases), we will see significant stress and concessions into Treasury auctions. This will coincide with the Congressional Budget Office forecasts of net funding needs approaching, or even exceeding, the levels that existed in 2009 and 2010.

After years of financial repression, with yields at historic lows and financial institutions on much firmer footing, and with an upturn in global synchronized growth, appetite for government securities is waning. Hence, we expect to see a steeper yield curve and wider MBS spreads.

More importantly we expect to see substantially more difficulty for the U.S. and European governments to issue debt at auctions and syndications. We might even see bond market vigilantes start to impose fiscal discipline on the U.S. government.

Said N. Haidar is founder and chief investment officer of Haidar Capital Management, New York. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.