by Andy Kochar, AGF Management Ltd.
The balance sheet of the U.S. Federal Reserve (Fed) has long been perceived as a key ingredient for the healthy returns that investors have enjoyed across asset classes over the last decade. As multiple rounds of quantitative easing programs were announced, the Fed in essence bought government and mortgage bonds in exchange for cash that was injected into the banking system in the form of reserves. Ideally, banks would then be able to make loans against these reserves to facilitate faster economic growth. Part of the intent to launch these programs was also to drive down long-term interest rates to promote borrowing.
As the economy started expanding and economic indicators such as the unemployment rate witnessed a precipitous drop, the Fed started unwinding its balance sheet by tapering its bond purchases because, in their view, liquidity injections were no longer required to support the economy. Fast forward to September 2019, the Fed’s balance sheet has resumed expansion and that too at a healthy clip.
The post-financial crisis regulatory regime has been particularly taxing on U.S. bank liquidity. Regulators and the Fed have pushed the banks to hold exponentially more capital, particularly in the form of reserves, to avoid a liquidity crunch should there be another banking crisis. But unfortunately for the Fed, almost two years of tapering resulted in a significant drainage of the very reserves that the banks need to meet regulatory needs, resulting in a mini-liquidity crunch in the overnight funding markets. Practically speaking, for financial markets to operate smoothly, the health of these funding markets is extremely critical day in and day out.
Is the current round of balance sheet expansion quantitative easing (QE)? Technically speaking, it has all the elements of what would constitute as a plain vanilla QE program, much like the ones announced by the Fed in the past. The only exceptions are the purchase of U.S. Treasury bills (T-bills) during this go around versus prior times when there were long-term bonds being purchased. Additionally, the Fed has been extremely clear during their messaging that this is not quantitative easing, quite simply because the current round of expansion is purely intended to fix the funding issue in the overnight markets, not to boost economic activity.
This recent round of expansion will result in a 15% increase in the Fed’s balance sheet over the first six months, compared to a best-case scenario of 2% GDP growth in the U.S. economy over the same period, according to Jefferies Financial Group Inc. research. That means the rate of balance sheet expansion is about seven times that of the economy. And while that doesn’t quite match the relative expansion in the Fed’s balance sheet of 12 times GDP growth during the QE era between 2008 and 2017, it is far more aggressive than the more normal course of expansion that happened in the pre-QE era between 1997 and 2007. In that stretch, the central bank’s balance sheet grew 60% in lockstep with the economy, the Jefferies research said.
While we acknowledge and are sympathetic to the nuances and intentions laid down by the Fed, it’s important to differentiate fundamental reality from stated intentions. During prior rounds of QE programs, the stated intention was always to promote faster economic growth. And yet after expanding the balance sheet to north of $4.5 trillion, U.S. real GDP has averaged only around 2% and yet the S&P 500 has quadrupled in price, according to Bloomberg data.
As we go into 2020, the Fed is resuming balance sheet expansion and for all intents and purposes, the rate of change of liquidity is turning from negative to positive. Even if the focus is currently T-bills, other market participants will be inclined to buy bonds farther out the curve due to the scarcity of T-bills. One must also combine that with the sizeable quantitative easing programs announced by the ECB. Historical liquidity injections have resulted in stronger risk asset classes, steeper yield curves, a weaker U.S. dollar, and stronger emerging markets (EM) amongst other things. In fact, since the balance sheet resumed expansion in late August, the S&P 500 is up, the Treasury yield curve has steepened, the U.S. dollar is down and EM equities are up.
Are the markets off to the races? In many ways, that would depend upon whether this recent round of expansion is adequate to calm the funding markets and whether it could result in a pause or an outright improvement in the health of the global economy. Looking at history, we do believe that financial tightening almost always precedes economic tightening. And conversely, one could argue for the opposite, although the response has not been symmetric (witness the anemic GDP growth this decade in spite of QE). This is an important development that could have significant ramifications for capital markets in the first half of 2020 as the rate of change of liquidity is moving from a drag to a net positive despite the Fed’s intentions.
Andy Kochar is a Portfolio Manager and Head of Credit at AGF Investments Inc. He is a regular contributor to AGF Perspectives.
The commentaries contained herein are provided as a general source of information based on information available as of November 1, 2019 and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
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This post was first published at the AGF Perspectives Blog.