Renewed expansion of Fed balance sheet will not be QE but will affect markets

Friday 08 November 2019

Investment Talks, Perspectives

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Contributing Authors

Paresh Upadhyaya
Director of Currency Strategy, US
Portfolio Manager

Christine Todd
Head of Fixed Income, US

  • Recent Fed action: On October 30th the Federal Reserve cut the federal funds rate for the third time this year, while hinting at a pause over the next few months. The rate cut followed the Fed’s announcement on October 11th that it will address a liquidity shortage causing volatility in the overnight loan market by buying $60 billion per month in Treasury bills until Q2 2020 and support overnight repo operations through January 2020.
  • Monetary policy impact: The most recent Fed balance sheet expansion is not meant to be Quantitative Easing1 , which the Fed implemented following the 2007-08 financial crisis. Current policy is not aimed at lowering longer-term interest rates and term premium to stimulate the economy. Instead, the Fed is calibrating the optimal size of its balance sheet and ensuring adequate liquidity in the system.
  • Market impact: The Fed could end up owning about 20% of the T-bill market by mid-2020, up from the current 1% according to Amundi estimates, potentially driving T-bill yields lower. This may create investment opportunities among shorter duration fixed income securities and sectors where the liquidity premium remains attractive, such as securitized assets, particularly where risk exposures are connected to the strength of the US consumer. Investors should reduce exposure to overall interest rate duration, as yields could bottom out, and to the corporate bond market, where increased scrutiny and selection are required as valuations have become rich in response to the global thirst for yield.

 

Why has the Federal Reserve announced renewed balance sheet expansion?

On October 11, 2019 the Federal Reserve announced it would begin buying Treasury bills (T-bills, bonds with duration of up to one year) to inject liquidity and stability into the overnight loan market and expand its balance sheet.

The Fed’s decision originates from the squeeze in the overnight repo market in September, when the cost of borrowing cash overnight jumped to 6% from around 2%, indicating a liquidity shortfall in the overnight loan market. The confluence of temporary and fundamental factors caused such dislocation. Cash exiting the market for corporate tax payments and US Treasury settlements were not offset by Global Systematically Important Banks reserves or a right-sized Fed balance sheet. Upward pressure on money market rates spilled over into the federal funds market rates. The Fed responded belatedly by injecting liquidity into the overnight lending market. This initial stop-gap activity was not enough to settle the repo market, prompting the Fed to announce planned purchases of $60 billion per month in T-bills at least through Q2 2020 and support for overnight repo operations at least through January 2020.

How does this action differentiate from QE?

There is some confusion among investors about whether the Fed’s decision to buy T-bills constitutes QE. By its broadest definition, QE is an unconventional monetary policy tool under which the central bank purchases government securities or other financial securities in order to inject liquidity into the system and help an economic recovery. This is not the goal of the most recent Fed action, which, as such, cannot be seen as a new round of QE. Actually, the Fed stated that these actions are purely technical to support the effective implementation of the Federal Open Market Committee’s (FOMC) monetary policy and does not represent a change in the US monetary policy stance. By buying T-bills with duration of up to one year, the Fed is not trying to lower longer-term interest rates and term premium to stimulate the economy. Instead, the Fed is calibrating the optimal size of its balance sheet. Additionally, the primary purpose of these operations is to ensure adequate liquidity in the system, which is not, by definition, QE’s goal. According to the Fed, the T-bill program “is designed to achieve ample reserve balances at or above the level that prevailed in early September”. The Central Bank “will conduct term and overnight repo operations at least through January to ensure that the supply of reserves remains ample even during periods of temporary, but pronounced, increases in our nonreserve liabilities, and to mitigate the risk that money market pressures adversely affect monetary policy implementation.”

Is the Fed’s decision unexpected?

No, the expansion of the Fed’s balance sheet is not an unexpected event. In July, the FOMC concluded its balance sheet reduction program which had been in place since October 2017. The Fed clearly indicated that, after a time, it would commence increasing its securities holdings to maintain reserves at a level consistent with an ample-reserves regime.

How will the Fed’s action impact market liquidity and USD trends?

Market liquidity is crucial to facilitate normal operations and asset price movements in financial markets.

As BIS research showed, flat yield curves, tight credit spreads and lower trading volumes may drive some players out of the market, possibly exacerbating market malfunctioning when central bank balance sheets are unwound. This is what happened following the latest Fed rate cut in September, which forced the Fed to inject $140 billion of liquidity into the market.

How will the Fed’s approach to liquidity impact the USD?

In the coming months, the Fed purchases of T-bills will total about $350-500 billion, building an adequate reserve buffer which should help stabilize the repo market and counter tightness in the US money market. This should remove one of the factors that have supported the USD so far this year, and could possibly drive the currency lower. Also, the Fed’s balance sheet will rise from around $4 trillion currently close to its peak of $4.5 trillion, facilitating a likely dollar weakness.

Which is the impact of the latest Fed’s purchasing program on the US fixed income market and how could investors benefit? 

At the current purchasing pace, the Fed could own about 20% of the T-bill market by mid-2020 up from the current 1%, according to Amundi estimates. Such demand will likely drive T-bill yields lower, possibly significantly lower. This could spill over into short-term Treasury coupons (1-3y) and short-dated agency paper.

One of the indirect consequences of the Fed’s repo action could be the steepening of the yield curve, as T-bill purchases of could help anchor short-term Treasury bond yields. This would allow the mid- to long-end of the US government bond market to react to inflation and global factors, such as emerging trends in the US-China trade tensions and Brexit.

Fixed income investors should be positioned not only to weather periods of market dislocation -- as experienced in the US repo market in September -- but also to capture value from oversold sectors and securities during dislocations. They may also consider positioning for a decline in the dollar and a steeping of the yield curve in response to the Fed’s current policy. Agility in portfolio management will be key for fixed income investing in 2020.

Quantitative Easing (QE): QE is a monetary policy instrument used by central banks to stimulate the economy by buying financial assets from commercial banks and other financial institutions.

Important Information

Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of October 30, 2019.

The views expressed regarding market and economic trends are those of the authors and not necessarily Amundi Pioneer, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Amundi Pioneer product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested.
This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service.

Date of first use: October 30, 2019

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