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President Donald Trump has been unabashedly vocal in his criticism of the Fed’s interest rate hikes, but the president has been quiet on another important Fed policy that may also be a big factor behind the rise in longer-term rates that influence all sorts of loans, including home mortgages.
On the surface, the Fed’s slow and steady approach to raising short-term interest rates once a quarter is less aggressive than it’s been in past cycles. But it’s the the Fed’s parallel balance sheet moves that have gone under the radar, except in the bond market where it is closely monitored.
That’s because the Fed has stepped back as a buyer in the Treasury market, at a time when the Federal government is also issuing a mountain of new debt. Since last year, the Fed has been gradually reducing the purchases it makes to replace Treasury and mortgage securities on its balance sheet as they mature.
“Investors are starting to realize just how many bonds are coming at us in the year and two ahead. And I’ve talked about this repeatedly over the last couple of years. We had a budget deficit in the United States that went up from around $600 billion a couple of years ago to now the official number for fiscal ’18 in now over $900 billion. But that doesn’t really capture how much debt is really being added to the national debt in the United States,” said Jeff Gundlach, DoubleLine CEO on CNBC.
Gundlach said there is also a loan to the Social Security system that takes the figure to $1.27 trillion. There are also pension liabilities and veterans benefits.
“On top of that you have the Fed now cranking up quantitative easing to $50 billion a month, which is another $600 billion for fiscal 2019 if they continue on that course. Which takes you to around $2.25 trillion of debt increase. And this is at a time where we’re supposedly in a good economy,” he said. The Fed’s $50 billion a month reduction includes both Treasurys and mortgages.
In an effort to help the economy and add liquidity to markets, the Fed loaded up on those securities during the financial crisis, in a then-controversial program, known as quantitative easing, or QE. The Fed’s balance sheet reached a whopping $4.5 trillion by late 2014, when former Fed Chair Janet Yellen announced an end to the program.
“Most people don’t understand the balance sheet because it’s never happened before. Equities went up because of the quantitative easing…Now they’re selling those assets, what do you think is going to happen now?” said Andrew Brenner of National Alliance.
It took the Fed another three years to start unwinding some of the effects of that so-called ‘quantitative easing’ program, or QE, but even now the Fed is taking the balance sheet unwind slowly. The balance sheet now holds about $4 trillion in securities, according to the Fed.
“They’re trying to undo a distortion,” said Diane Swonk, chief economist at Grant Thornton. “It means they’re no longer stepping in and buying. The whole idea was to take term premia out of the long bond.” Swonk said the Fed used its balance sheet program to hold down interest rates by buying bonds, and continued to hold them down as it held onto those securities. Bond yields fall, as bonds prices rise.
Bond market pros say it’s difficult to gauge just what type of impact the Fed has had on rates, but it’s getting more attention since the slowdown in purchases comes as the U.S. government’s borrowing needs are dramatically rising, in part, to fund tax cuts and fiscal stimulus.
Strategas Research estimates the Fed’s balance sheet unwind is equal to just a half a rate hike per year.
“The bottom line is it makes the hikes much more effective. It puts the bonds back in the market and someone else has to buy them. At a time when we have massive deficits, it’s just compounding the pain, and it’s only just started,” said George Goncalves, fixed income strategist at Nomura. Goncalves said when the Fed initially made the QE purchases, they helped make zero or low rates more impactful.
On a global basis, the Fed is leading the way in terms of reversing QE, with Japan still buying heavily and the European Central Bank just winding down its purchases this month.
“The fourth quarter could be the perfect storm. The ECB’s not buying which means the Europeans aren’t going to buy our debt. They have their own. The U.S. has this deficit to finance and you need higher rates to attract capital,” Goncalves said.
He said the Treasury Department could send another ripple through the market when it announces its refunding needs at the end of this month. On Friday, the Treasury asked bond market dealers how they expect to see the Fed unwind its balance over the next three years.
Many dealers have expected the Fed to reduces the balance sheet by $1.5 to $2 trillion.
The recent move higher in interest rates came on the heels of good data, but also as Fed Chairman Jerome Powell said last week that the Fed was nowhere near the neutral rate, or rate that would no longer be stimulative. The 10-year yield, below 3 percent a month ago, rose as high as 3.26 percent this week. It has since pulled back in this week’s violent stock market sell off. The 10-year is the benchmark that is used to price mortgages and other consumer and business loans.
The jump in longer term rates over the past two weeks, specifically on the longer term 30 year bond and the 10 year Treasury note, sent a shudder through the stock market. Investors worry that higher rates could slow activity, driving up costs for corporations and consumers, while also creating opportunities in fixed income that would siphon funds from the stock market.
Trump blamed the Federal Reserve for the stock sell-off, which sent the Dow down more than 1,300 points in just two days Wednesday and Thursday. The Dow was higher Friday.
“I think the Fed is making a mistake. They are so tight. I think the Fed has gone crazy,” the president said. He said the Fed does not need to keep hiking because inflation is low.
Trump had blasted the most recent September rate hike earlier. At the time, he said he was “worried about the fact that they seem to like raising interest rates, we can do other things with the money,” he said.
Indeed, the Fed has pushed up short-term rates by raising its fed fund target rate range seven times, after holding it near zero for years after the financial crisis. But the fed funds target range is 2 to 2.25 percent, well below the 3 percent that many see as neutral.
“[QE] helped to lower rates. They’re no longer doing that, and it’s more complicated now then when the Fed first started on autopilot with reductions in its balance sheet,” Swonk said. The complication is that the deficit will swell to more than $1 trillion in 2019, with spending for tax cuts and stimulus.
“The federal government has more bonds to sell, and you don’t have an extra buyer,” said Swonk. Even China, the biggest holder of Treasurys has been buying less, though it is not a seller.
Goncalves said the Fed may reveal some of its thinking on the balance sheet when it releases minutes of its last meeting on Wednesday. Powell had targeted this fall as a time for the Fed to review its balance sheet policy.
“We should be applauding the Fed and Powell for being successful and extracting the Fed out of the market without imploding. We should be applauding the U.S. capital markets. We should be happy about that. It’s the ultimate sign of success. We’re getting out of the QE business,” said Goncalves.