Eight Months into Quantitative Tightening: Where Are We Now?

It has been eight months since the Federal Reserve began its balance sheet reduction program, affectionately adapted as "quantitative tightening (QT)" by Wall Street, the opposite of the "quantitative easing (QE)" program the Fed used to purchase securities after the 2007-2009 recession.

The pace of this balance sheet 'normalization' program was outlined in the Federal Open Market Committee's June 2017 policy meeting as an addendum, and was outlined as below:

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

So, for Treasuries, the Federal Reserve began "rolling off" $6 billion worth of securities each month in 2017 Q4, and then $12 billion of securities each month in 2018 Q1, now at an estimated $18 billion per month in 2018 Q2. In July, that pace will again accelerate to $24 billion per month for the third quarter. For mortgage-backed securities (MBS) and agency debt, the initial pace in 2017 Q4 was $4 billion per month, then $8 billion per month in 2018 Q1, followed by $12 billion per month now in 2018 Q2. Similarly, this will increase again to $16 billion per month in 2018 Q3.

Adding it all up, the second quarter of 2018 is seeing the Federal Reserve "roll off" $30 billion in securities per month, for a cumulative $90 billion in securities released for Q2. When Q3 rolls around in July, the total number of securities coming off the Fed's balance sheet each month will ramp up to $40 billion, for a cumulative $120 billion balance sheet reduction in 2018 Q3.

This process is not an exact science, of course, so these numbers are more reference points than anything. But data from the Federal Reserve shows that this process is already well underway.

Source: St. Louis Federal Reserve FRED

The size of the Federal Reserve's balance sheet has shrunk from $4.46 trillion on October 4, 2017 to $4.32 trillion as of June 6, 2018, for a total reduction of $140 billion. By the math and FOMC guidelines above, through May 2018, roughly $150 billion in securities should have already been subtracted from the balance sheet. In the broad scheme of things, this discrepancy is pretty minor, and the key takeaway is that the Fed is proceeding with its balance sheet normalization program pretty much as advertised.

One of the main worries about quantitative tightening is that this increased rush of Treasury debt supply would ratchet up U.S. bond yields, thereby tightening domestic (and, for all intents and purposes, global) financial conditions as interest rates on mortgages and other consumer debts rise as well. Has this worry panned out?

Source: St. Louis Federal Reserve FRED

It is not debatable that U.S. Treasury yields have increased since September/October 2017. The 10-year Treasury note yield (the red line above) has risen from ~2.1% in September 2017 to as high as nearly 3.1% in May 2018. That's an increase of about 100 basis points in just under eight months- a non-trivial increase. However, it is wrong to fully attribute this increase in bond yields to the Fed's balance sheet reduction program, no matter how enticing the above chart makes that conclusion.

First, global growth was seen picking up to end 2017. Indeed, the phrase 'global synchronized growth', or something similar involving the word "synchronized", became quite popular as both advanced economies (AEs) and emerging market economies (EMEs) saw economic output kick into a higher gear. 

Prior to this, the United States was holding the honor of comparatively-strong economic growth; the eurozone continued to shake off scars from both the financial crisis and sovereign debt crisis into the middle of this decade, while China took a hard stumble near the halfway point of the decade. India's sudden demonetization injected uncertainty into the minds of foreign investors, and a less-than-stable banking system continues to stand in the way of more sustained and confident economic growth. 

However, 2017 saw the core of the eurozone - especially Germany - regain its economic mojo, with German real GDP growing at an annual rate of 2.9% in 2017 Q4, the highest mark since 2011 Q3. Worries over the Italian banking system were soothed as the largest trouble spots - Banca Monte dei Paschi di Siena and two regional banks - were cleanly dealt with. Elections in several major EU countries saw populist candidates lose out, much to the cheer of investors. Outside of the EU, China beat expectations with 6.9% annual GDP growth for 2017, African nations continued to see infrastructure investment as part of China's Belt and Road Initiative (BRI), and protectionist fears around the globe, aimed primarily at the U.S., were put off ... until this year, apparently.

The rebound in global economic growth provided a very convenient excuse for investors to diversify their portfolios and pursue investments in the eurozone, Africa, and other regions. The comparative decrease in the attractiveness of U.S. assets was likely a factor in sending U.S. interest rates higher.

Second, the new U.S. spending bill passed at the tail end of 2017 requires a significant uptick in the issuance of U.S. Treasury debt. This is an added supply burden to the increased supply already in place from the Federal Reserve's balance sheet runoff, and it's quite likely both the expectation and reality of increased Treasury debt supply due to the spending bill boosted U.S. bond yields.

Thus, while the Federal Reserve's "quantitative tightening" program is more than likely raising U.S. interest rates (and will likely continue to do so as the program's pace accelerates), there are other factors at play that have helped to keep interest rates elevated.

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So, where are we now? The Federal Reserve Bank of Chicago's Adjusted National Financial Conditions Index (ANFCI, a preferable acronym to that whole mouthful), a good way to see how easy or tight financial conditions are, has indeed increased since November 2017, but remains solidly in negative territory. In the ANFCI, negative values imply easier financial conditions.

Source: St. Louis Federal Reserve FRED

Warranting more attention than the ANFCI is the rise in mortgage rates, which have jumped from 3.90% to start December 2017 and peaked at 4.66% on May 24, 2018- a rise of 76 basis points in about six months, again a non-trivial movement. 

Source: St. Louis Federal Reserve FRED

I believe this rise in mortgage rates will eventually hurt housing, but I could (and probably will eventually) write a whole separate post about the reasons why and why not these higher rates could hurt housing this year. For this post, though, it's likely that the Federal Reserve's "quantitative tightening" program has helped increase mortgage rates, again combined with other factors.

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In general, these effects of higher U.S. bond yields are not yet significant, particularly when compared to yields of over 5% as recently as the eve of the financial crisis. It's plausible that there is some "sticker shock", particularly with respect to the higher mortgage rates, but aside from this the effects of the Federal Reserve's balance sheet runoff have not been debilitating, or even so much as notably inhibiting to the financial system. Indeed, "cov-lite" leveraged loans remain a hot commodity in global financial markets.

For now, "quantitative tightening" is more akin to a few gentle turns of the screwdriver than an electric drill. Perhaps in another eight months, the screws will have tightened even more... or perhaps too much more.

Andrew