The QE Unwind May Not Be Occurring As Planned

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Summary

  • The Federal Reserve guided it would unwind its balance sheet by $10B/month starting in October.
  • However, the Fed’s own data shows it has been occurring at a substantially slower pace.
  • The lack of full unwinding may explain phenomenon in the bond and stock markets.

The Fed announced a QE unwind

At the September 2017 FOMC meeting, the Federal Reserve indicated it would start to reduce its $4+ trillion balance sheet beginning in October 2017. The Fed accumulated such a large balance sheet by buying Mortgage Backed Securities (“MBS”) and Treasurys in the quantitative easing programs.

The initial pace of the reduction of assets was set to be $6 billion per month in Treasurys and $4 billion per month in MBS. The unwind would not involve directly selling bonds to the market, but instead, the Fed would merely let the aforementioned amounts of assets mature each month without automatic reinvestment, which would in effect reduce the size of the balance sheet as an open market sale would, but in a more gradual, less blunt fashion.

Then, each quarter the pace of reductions would accelerate until it reaches a pace of $30 billion per month for Treasurys and $20 billion per month for MBS, or $50 billion total per month. As a result of a $600 billion annual pace of reduction eventually being reached, William Dudley’s goal of a $1-$2 trillion total reduction would take about 2 to 3 years total. The Fed implicitly believes 2-3 years would be a short enough time before the next recession would strike, where a switch to accommodative policy would be needed.

The QE unwind has been occurring at a much slower pace

The Fed’s own H.4.1 data series shows a much slower pace of balance sheet reductions for Treasurys holdings.

According to the data provided from FRED, the Fed’s Treasurys holdings only dropped about $11 billion from the end of September 2017 through December 21, 2017. We would otherwise expect the unwind for Treasurys to have been closer to $18 billion over the near 3-month period, assuming a targeted $6 billion per month rate.

For MBS, it is more difficult to track the changes with there having been more volatility week-to-week in the past. But based on the Fed’s FRED data from H.4.1 series, there doesn’t appear to have been any sustained reduction in the MBS holdings, since the holdings as of December 21 are greater than they were going into October on the September 27 update.

The lack of the full unwind pace may explain stock and bond market action

In the past, QE programs have led to rallies in the stock market and declines in the Treasury market, as bond yields historically have surged during QE. As a result of this trend, one reasonably would expect the opposite to occur during QE unwind—that is an expectation of headwinds for the stock market, and a push higher for Treasurys, leading to lower yields. I discussed these expectations in the piece, “What to Expect From the Fed’s QE Unwind”, in August 2017.

However, since the announcement of the unwind of QE on Wednesday September 20, 2017, the S&P 500 has rallied sharply from 2508 to the 2683 level, as of the close of December 22, for a 7% price rally in about 3 months.

Over the same time period, the 10-year note yield has also risen from 2.28% on September 20 to 2.48% as of the close on December 22, 2017.

The recent 3 months have had a sharp rally in both bond yields and the S&P 500, which is the opposite of what one may have expected from the unwind of QE. In fact the sharp rally in Treasury yields and stocks is what was observed during QE programs in the past, and a surprising effect of a QE reversal. However, an explanation for the apparent anomaly may be that the unwind is not occurring as projected, in fact it is barely occurring at all (especially for MBS).

Also, the tax reform plan has just been signed into law, and that is expected to be very inflationary, and boost S&P 500 earnings, which would lead to higher stock prices and yields, the opposite of QE unwind. Therefore, another explanation may be the acute impact of tax reform may be over-powering the effects of a QE unwind.

Conclusion

The Fed may not have been executing the QE unwind at the same pace at which it guided when it announced the program in October. This conclusion is backed by the Fed’s own H series data. The stock and bond markets have had inflationary reactions lately, which is counterintuitive given the deflationary nature of the unwind. The two culprits of the unexpected market reactions may be the tax reform serving an inflationary element that counters and overpowers the effect of QE unwind, and also, the fact that the data shows the unwind may not have really been implemented as planned.