Quantitative tightening

Transcription

1 ECONOMIC RESEARCH DEPARTMENT Quantitative tightening The US Federal Reserve (Fed) is putting its balance sheet on a diet, which should see it reduced by one-third by the end of Although inflation is not a problem, the risk of financial instability in the United States is rising. Barring unexpected events, monetary tightening will continue. This could end up slowing the equity market, which is currently displaying high multiples and increasingly relies on leverage. It could also result in an increase in the risk associated with corporate debt, both in the USA and in developing countries. A major turn: from this month, October 2017, the Fed is putting its balance sheet on a diet. For all the efforts of the Fed s Chair, Janet Yellen, to talk down the impact of the move 1, it is a delicate operation, if only because of the sums involved. Towards dearer dollar loans Since the financial crisis of 2008, the Fed has made net asset acquisitions of some USD3,500 billion, a fivefold increase in the size of its balance sheet (see box, page 2). It now holds 18% of the stock of US Treasury negotiable debt (Treasuries) and 2 of the stock of Mortgage-Backed Securities (MBS). If it sticks to its route map, assets will be reduced by USD1,500 billion, or 33%, by the end of This should bring back its balance sheet to an equivalent of 13% of GDP at that stage, from 23% now. Although it is hard to predict, one should not assume that the effect on interest rates will be negligible. The Fed s economists estimate that the three successive waves of quantitative easing contributed around 100 basis points to the fall in the term premium, which has been in negative territory since 2012 (Figure 1) 2. But for the Fed s assets purchases, and all other 1 In a press conference following the Federal Open Markets Committee in June 2017 the Fed s Chair, Janet Yellen, said that following the process of reducing the Fed s balance sheet would be as dull as watching paint dry. 2 See Bonis B., Ihrig J., Min Wei M. (2017) The Effect of the Federal Reserve s Securities Holdings on Longer-term Interest Rates, FEDS Notes, April. Fed balance sheet vs. US interest rates Total Federal Reserve assets, % of GDP [rhs] --- Yield on 10-year Treasury bonds [lhs] 6% 5% 4% 3% 2% 1% -1% Note: Projections of the Fed s balance sheet are in line with the median scenario provided by the Federal Reserve of New York in July Nominal GDP is extrapolated at its trend growth rate (4% per year), obtained using a Hodrick-Prescott filter. The term premium can be defined as the arbitrage cost between a long bond investment subject to random variation prior to maturity (the price of the bond on the secondary market varies) and a rolling short-term investment. It is stated as the difference between the nominal return of a bond and the compounded expected future short-term interest rate over the maturity of the said bond. The latter is clearly not directly observable and is the product of approximations using various methods. The figures used here are those provided by the Federal Reserve of Saint Louis and are based on the results of a model developed by Kim and Wright (2005). See Kim D.H. and Wright J.H. (2005) An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates, FEDs Working Paper n , August. Figure 1 things being equal, the yield on ten-year Treasuries would therefore now be closer to 3.3% than to 2.3%. If the reverse holds true, a shift to a regime of net asset sales is thus likely to reduce prices (pushing up yields). Assuming a relationship that mirrors that of Bonis and Ihrig (2017) 3, the process of normalising the Fed s balance sheet, between now and end-2020, will result in an increase of around 60bp in the 3 Ibid. Term Premium Projection Source: Federal Reserve economic-research.bnpparibas.com Jean-Luc Proutat 20 October

2 10-year term premium. Again, this effect is assessed with all other things being equal. It may be combined with other effects. The influence of expectations of short-term interest rates is, of course, dominant. And in this area, the risk could also be upwards. There is a degree of lag between the market s expectations, which are fairly conservative, and the more aggressive projections of the Fed. Adopting the expected inflation rate of 2%, which corresponds both to the official target and to indexlinked 10-year swap rates, the real equilibrium rate targeted by members of the Federal Open Markets Committee (FOMC) is 0.8%, whilst that expected by the market is some 40bp to 50bp higher. 4 In total, and in order to not get too far from its route map, US monetary policy will probably contribute to raising interest rates by around 100bp over the next two years. The reversal of quantitative easing will act in favour of a re-emergence of the term premium, while a higher target rate for fed funds would prompt a normalisation of expectations of short-term rates. Cause and consequences Why put the brakes on when the inflationary trend (1.7% per year in August, excluding food and energy) remains below the official target and the economy is still not back up to its potential? One possible explanation is that the Fed is now focusing on reducing the risk of financial instability. This initial function 5 of the Fed normally plays second fiddle to macroprudential policy. However, it has come increasingly to the fore in FOMC discussions since the financial crisis (see Peek, Rosengren, Tootell, ). Although it is not at the heart of monetary policy, it can nevertheless have an influence. The interest rate weapon allows the Fed to target non-banking entities (investment or arbitrage funds, trusts, etc.) over which is has less power but which may be making increasing use of borrowing to finance their activities. The fact is that borrowing for leverage purposes has seen rapid growth in recent times. According to estimates from the Bank for International Settlements (BIS), loans used to buy equities have hit new record levels in the USA. Such borrowing has now beaten the levels seen in 2005 or during the internet bubble at the end of 4 Figures estimated in September The Fed s real interest rate is derived from the projections of long-term Fed Funds rates (2.8%), less the target inflation rate (2%). It therefore stands at 0.8%, whereas it was closer to 2% prior to the financial crisis at used at that level in the Taylor rule. See, for example Brainard, L. (2015) Normalizing Monetary Policy When the Neutral Interest Rate is Low, Remarks at the Stanford Institute for Economic Policy Research, December. The average of 10-yields on Treasuries in September 2017, was 2.2, with an associated term premium (derived from the Kim & Wright model) calculated at -0.24%. This puts the expected short-term rate over a long period at 2.44%, or 0.44% in real terms (again with expected inflation of 2%). 5 It is worth remembering that the Federal Reserve system was set up in 1913 precisely to promote financial stability. See 6 Peek J., Rosengren E., Tootell G. (2017) Should U.S. Monetary Policy Have a Ternary Mandate?, Contribution to the 59 th Economic Conference of the Federal Reserve Bank of Boston, October. Flux and reflux Chairman of the US Federal Reserve from 2006 to 2014, Ben Bernanke is also one of the foremost experts on the depressive mechanisms of the 1930s. Author of several essays on the subject, he is well aware that the disordered liquidation of debts can lead to chaos, and that to avoid this the Central Bank must be able to play in full its role as the lender of last resort, even if this means using relatively unconventional tools. This is what happened from the onset of the financial crisis in 2008, when, in a market that had become illiquid, the Fed started to take as collateral and then to acquire Mortgage-Backed Securities (MBS). Various programmes and as many acronyms were created, which contributed to inflating the Fed s balance sheet. PPAD (Planned Purchases of Agency Debt) and TALF (Term Asset-Backed Securities Loan Facility) were introduced in the autumn of They fed a first wave of purchases of debt, namely debt issued or guaranteed by mortgage agencies, and established quantitative easing (QE) as a new instrument of monetary policy in the USA. Other programmes were to follow. In November 2010, the Fed announced QE2 and expanded its asset purchasing to US Treasuries. It launched the twist operation, extending the maturity of its balance sheet in September 2011, and then QE3 in September In all between September 2008 and October 2014 (the end of QE3), the Fed has acquired some USD3,500 billion of assets, multiplying the size of its balance sheet fivefold. At 20 September 2017, it held USD4,511 billion in assets, including USD2,465 billion in US Treasury bonds (18% of the negotiable total) and US1,776 billion in MBS (2 of total outstandings). The onerous task of getting things back to normal has fallen to Mrs Yellen, who succeeded Mr Bernanke at the head of the Fed in In June 2017, the process of reducing the institution s balance sheet was set out. From October 2017, the Fed set limits on the amounts that it reinvests on maturity, which corresponds to an equivalent net sale of securities. The route map is as follows: - The holding of Treasuries will be reduced by a maximum amount of USD6 billion per month, a ceiling that will be raised by USD6 billion every three months, taking it to USD30 billion after one year. - The holding of MBS will be reduced by a maximum amount of USD4 billion per month, a ceiling that will be raised by USD4 billion every three months, taking it to USD20 billion after one year. Unless there is some substantial deterioration in economic conditions, the cruising rate reduction in the size of the balance sheet will therefore reach a maximum of USD50 billion per month by the end of 2018, shrinking the Fed s balance sheet to between USD2,800 billion and USD3,000 billion by the end of Box 1 Source: Federal Reserve the 1990s, and is feeding the rise in prices (see Figure 2 and BIS, 2017) 7. In the corporate debt segment, it is contributing to the crushing of risk premium or spreads. More worryingly, the quality of assets that these loans are used to finance is tending to fall, as reflected in the growing number of bond issues without contractual commitments (covenant lite) or with less onerous covenants. Already highlighted by the International Monetary Fund (IMF) 8, the deterioration in credit fundamentals has recently gathered pace in the USA. 7 The net margin debt on equity markets, that is to say the difference between credit balance of cash trades and margin trades for equities less the debt on margin trades, reached a record USD254 billion in August See Bank for International Settlements (BIS), Quarterly Review, September There has been a stronger reliance on debt financing as the credit cycle entered a mature phase. Corporate credit fundamentals have started to economic-research.bnpparibas.com Jean-Luc Proutat 20 October

3 The relatively low level of US interest rates has also boosted the rapid expansion of dollar-denominated debt in emerging economy, the total outstanding amount of which has more than doubled since the 2008 crisis and is now at a cyclical high relative to GDP (Figure 3). The US currency has also been at the heart of carry trade operations that, in 2017, have fed into a renewed flow of capital into developing economies. Here too, the trend has contributed to a rise in asset prices (equities and corporate bonds) and a compression of spreads. Given that surplus reserves of dollars are subject to global recycling, their absorption by the Fed is likely to have various consequences. What will these be? Looking at US equity market and supposing that valuations remain at current highs, a 100bp rise in US interest rates would cut the risk premium close to zero 9, increasing the likelihood of a cooling of the market. Leverage could act in both directions (see Box 2), with the reversionary force proportional to that which has contributed to increasing multiples. As for corporate debt, whether in the US or emerging economies, increasing the scarcity and cost of dollar liquidity will produce a widening of spreads, probably producing a brake on credit and investment spending. As carry trades are unwound in whole or in part, the US dollar will strengthen against emerging economy currencies, accentuating the difficulties for some of these countries. Lastly, it is conceivable that the cost of government borrowing could rise, notably in the euro zone where the Fed s quantitative easing has been used for the acquisition of government debt. The scale of the adjustment will however be limited by the fact that governments are reducing their borrowing requirements, and other institutions, not least the European Central Bank, are maintaining very accommodating monetary positions. Jean-Luc Proutat jean-luc.proutat@bnpparibas.com weaken, creating conditions that have historically preceded a credit cycle downturn. See IMF (2017), Global Financial Stability Report, Chapter 1, p. 9, April In the so-called Fed Model simplified approach, the risk premium is defined as the difference between the inverse of the price/earnings ratio (PER) and the risk-free 10-year rate (Treasury yield). Thus for respective levels of 30 and 3.3%, = 1/30 3.3%. US equity market expansion Adjusted* PER of US equity market (rhs) Net margin debt / GDP (lhs) 2% 1% -1% -2% * Price-to-earnings ratio estimated on the basis of cyclically-correct full-year earnings for companies in the Standard and Poor s 500 index. Figure 2 Sources: Shiller, BIS, Thomson Reuters Dollar-denominated debt in emerging economies USD bn Figure 3 Sources: BRI, FMI The leverage mechanism To understand the link between leverage and the return on capital, we can break down the equilibrium of sources and applications of funds and also the profit and loss account of companies as follows: (1) A=SE+D (2) NP=ER-I where A is all assets, D is debt, SE is shareholders equity, NP is net profit, ER is economic return and I is interest costs. Leverage (L) allows a holding of assets that is greater than shareholders equity; thus by definition, (3) L = A / SE; The economic yield (ey) of assets is defined as the ratio of economic return to total assets, giving ey = ER/A; The return on equity (roe) is defined as the ratio of net profit to shareholders equity, so that roe = NP / SE. Therefore: (4) roe = NP / SE = (ER I) / FP from (2) = (ey.a i.d) / SE where i = interest rate = [ey.(d + SE) i.d] / SE from (1) = ey + (ey i).(l-1) from (3) Borrowing (giving L>1) increases (reduces) the return on equity relative to the economic yield provided that the interest rate i is lower (higher) than this economic yield. Box % GDP economic-research.bnpparibas.com Jean-Luc Proutat 20 October

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