DOUBLE, DOUBLE TOIL AND TROUBLE. "TREASURIES" BURN AND "MARKETS" BUBBLE / SPROTT ASSET MANAGEMENT

Double, double toil and trouble. ‘Treasuries’ burn and ‘markets’ bubble

Tuesday, November 26, 2013

David Franklin


The Federal Reserve has created an economic problem worthy of a Shakespearean tragedy. On the one hand they have worked tirelessly to support the markets and prevent an economic depression while on the other hand, they have also created a problem for which is no clear solution. The bond buying program instituted by the Fed has been similar to casting economic spells over global markets, convincing them that all is well.

However, deciphering their next move has been an exercise in reading economic entrails for forward guidance. You can imagine the twelve ‘witches’ of the FOMC mixing a brew of unemployment statistics, GDP forecasts, inflation expectations and shreds of economic data into a ‘witches brew’ that will determine whence tapering begins. The market is obsessed with this date and it has coloured every significant market movement since the Fed shocked market watchers and delayed ‘the taper’ after their meeting in September. Market indices have gyrated with economic data as they get added to the cauldron of economic decision making that the twelve governors stir to generate apparitions for market participants to interpret. These images have bedeviled markets in a ‘fair is foul and foul is fair’ interpretation of events. Even yesterday, a gauge of upcoming home sales fell in October for the fifth straight month, the latest sign that higher prices and borrowing costs are denting the housing rebound. While this news should be negative for the stock market, in fact it rallied, in hopes that tapering might be delayed and continued stimulus would push markets even higher.

The latest housing data "are a reason for the Fed to remain cautious” about slowing the bond-buying, said Jim O'Sullivan, chief U.S. economist at High Frequency Economics. Once again market participants are left to interpret the foggy images appearing above the economic cauldron the FOMC stirs for guidance.

Fed officials will next meet on Dec. 17-18 to evaluate whether the economy is strong enough for the central bank to start reducing the pace of its monthly bond purchases. However, four of five investors expect the Federal Reserve to delay a decision to begin reducing its bond buying until March 2014 or later, with just 5% looking for a move next month, according to the latest Bloomberg Global Poll. Those forecasting a cutback in March or later are split evenly between those who expect a move that month and those who see it afterward.

Only one in 20 said the central bank will begin to reduce its purchases at its Dec. 17-18 meeting, according to the poll yesterday of investors, traders and analysts who are Bloomberg subscribers.1 Let’s consider the consensus scenario where the Federal Reserve tapers its monthly bond-buying by $10 billion per month starting in March of 2014. What a ‘tapering’ of purchases would look like is best shown by the Federal Reserve Balance sheet shown below.

In figure A, we took the Federal Reserve’s aggregate balance sheet from January 2007 to October 31, 2013 and then we projected the consensus estimate that the Fed would taper purchases by $10 billion per month to December 2014. Can you spot the two lines on the graph in the upper right hand corner? The lower line is a projection of the Federal Reserve balance sheet if additions are reduced by $10 billion per month from the current $85 billion. You can see the impact is only a very minor variance in the total size of the balance sheet. In fact, once you dig into the numbers a little deeper, the difference becomes even smaller. According to data compiled by Bloomberg, the Federal Reserve’s balance sheet has been increasing at an average rate of $93.453 billion each month from January to October of 2013.

While the Federal Reserve has been buying assets at a rate of $85 billion per month, they have also been further adding to their purchases by including interest proceeds and maturing bonds further adding to their total balance sheet. In fact the largest single monthly addition to their balance sheet in 2013 was during the month of April when the Federal Reserve added $114.723 billion of assets. Therefore if you reduce purchases by $10 billion per month, on average in 2013 that would reduce purchases to just over $83 billion per month. This is hardly a drastic reduction in their quantitative easing program, yet the market has launched into a frenzy over this potential change in policy. The predominant view inside the organization is that as long as the stock of bonds on the central bank’s balance-sheet keeps growing, monetary policy is getting looser. Financial markets have clearly concluded otherwise. Investors interpreted the promise of tapering as evidence of a big shift in the Fed’s priorities when in fact our data shows that tapering will have only a small effect on the growth of the balance sheet.



FIGURE A: FEDERAL RESERVE BALANCE SHEET – JAN 2006-2014
Source: Bloomberg and Sprott Asset Management 


We project a balance sheet of over five trillion dollars by the end of 2014, which gives us pause. While it is true that monetary policy is loosening at a slower rate, an estimated five trillion dollar balance sheet is breathtaking to behold. The question that immediately comes to mind is ‘how will the ‘twelve witches’ of monetary policy conjure a reduction in the Fed balance sheet to pre-crisis levels?’ On the eve of the Feds first quantitative easing program back in 2008 the balance sheet stood at a mere $940 billion. At the end of 2014, the Federal Reserve balance sheet will top five trillion dollars. Reducing the balance sheet by four trillion dollars is a feat that no mere mortal can attain without pushing interest rates up and inflicting heavy losses on its portfolio holdings. A devilish paradox becomes apparent that since the Fed owns so much of some classes of assets, it has become the market for these assets and any significant effort to sell would send prices down and yields up, producing large losses for the Fed. The price of today’s 10-year Treasuries would fall by about 2% if yields rose to 2.8% from today’s 2.6%, which is big money if you hold $2 trillion in Treasuries. Current holders of Treasuries are already looking at a loss position in 2013 and an increase in rates would further add insult to injury. As the Federal Open Market Committee stirs its cauldron of economic data in hopes of determining a proper date for tapering, we are far more concerned about how a reduction in the size of the balance sheet will affect the market.

While we listen to the double-speak and contradictory voices of the Federal Reserve governors in speeches and interviews and ponder the economic data, we can’t help but see imaginings in the near future where treasuries ‘burn’ and markets ‘bubble’ as the Federal Reserve tries to devise an exit strategy from its bloated balance sheet. In the final act of this Federal Reserve ‘play’ we will find out if they can manage the paradox of massive market intervention and then an elegant withdrawal or if its actions will end in tragedy.