Wednesday, August 17, 2016

The Unwinding of QE Has Begun

Don't look now, but the Fed is quietly unwinding QE. As seen in the figure below, the Fed's share of marketable treasuries has been shrinking:

To be clear, this is a passive unwinding of QE. The Fed's treasury holdings have not changed, but the stock of marketable treasuries has grown. Nonetheless, this is still an unwinding according to the portfolio channel of monetary policy. This channel says the Fed's taking of safe treasury assets from the public would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower interest rates, push up asset prices, and help shore up the recovery.

Now the portfolio channel should be working in reverse. The public is getting a larger share of treasuries relative to the Fed thanks to the ongoing budget deficits. Moreover, this passive unwinding by the Fed is being reinforced by other central banks according to CNN Money:
In the first six months of this year, foreign central banks sold a net $192 billion of U.S. Treasury bonds, more than double the pace in the same period last year, when they sold $83 billion. 
China, Japan, France, Brazil and Colombia led the pack of countries dumping U.S. debt. It's the largest selloff of U.S. debt since at least 1978, according to Treasury Department data. 
"Net selling of U.S. notes and bonds year to date thru June is historic," says Peter Boockvar, chief market analyst at the Lindsey Group, an investing firm in Virginia.
So have all these central bank actions caused U.S. treasury yields to take off? Have the Bill Grosses of the world finally vindicated themselves? The answer is no. Treasury yields continue to remain at historic lows despite the unloading of treasuries by central banks. How can that be? Here is CNN again with the answer:
Despite all the selling by these countries, private demand for the bonds has sky rocketed. Demand is so high that the U.S. can afford to pay historically low interest rates. The 10-year U.S. Treasury hit a record low of 1.34% earlier this year, before bouncing back to about 1.58%, currently.
In other words, central banks have not been very important in shaping the path of long-term treasury yields. You, me, and our financial intermediaries, on the other hand, have been a key reason for the decline of U.S. treasury yields to historic lows. While not the only factor, our seemingly insatiable desire for safe assets has been a pivotal factor behind the low interest rates. And, as can be seen in the figure below, the decline in safe asset yields is a global phenomenon:

This is the safe asset shortage problem. As seen in the figure, the trend in safe asset yields turned down in 2008. This common change in trend should reinforce the point above that this is not a consequence of central bank's actions. Instead, as outlined here, the safe asset shortage problem is the consequence of a reduction in the supply of safe assets, an increase in demand for them, and an ongoing spate of bad economic news that keeps this economic sore from naturally healing. 

The failure of treasury yields to rise with the unwinding of QE is just another data point that confirms this understanding. Here's hoping the Bill Grosses of the world take note. 


  1. I think you make a good point, about QE and about the effects of supply/demand forces. Re the latter, I always got a kick out of those Wall Street guys who thought that capital fight out of China, passively accommodated by official China Treasury sales, should have pushed UP US interest rates. Talk about missing the forest for the trees. However, skeptical you are about Wall Street sales commentary, I would urge you to become more so. Many of these guys are like chimps, able to put the bananas in the one pile and the grapes in then other, and then to count each on their fingers. They would not get that they are dealing with something called "fruit." That is too abstract.

    Having said that, I prefer Larry Summer's measure of the scale of QE. Don't take QE as a ratio to Treasury debt. Rather, calculate the difference between Treasury debt and QE, ideally measured in duration equivalents, and then normalize that by GDP. (I guess GDP would be a proxy of shadow supply and demand for duration, in this case.) That is also imperfect, for the simple reason that net supply does not determine price, just as you emphasize. But I think it is closer to the spirit of what QE advocates CLAIM for the program. If you want to test their claims, you might want to use their metric?

  2. It seems quite clear to me that we don't have a Safe Asset Problem. What we have is a distribution-of-income/saving problem.

    As I try to explain in
    the fundamental cause of this problem is the increase in the concentration of income that has taken place over the past thirty years, and as I try to explain in
    trying to solve this problem through monetary and fiscal policy alone is unsustainable so long as these policies increases debt relative to income without reducing the trade deficit and concentration of income.

    This is the kind of situation we faced in the 1930s. Monetary and fiscal policy propped up the system following 1933 along with the concentration of income, but the problem itself wasn’t solved until World War II came along, the government completely took over the economic system, and the concentration of income fell dramatically.
    ( )

    Hansen understood this problem in terms of the lack of investment opportunities when he gave his address on secular stagnation in 1938 as did Samuelson when he included consumption as the motivator of investment in the accelerator process. But neither of them thought in terms of the connection of income. As a result, the contribution of the fall in the concentration of income that took place during World War II to the prosperity that followed the war was not understood by mainstream economists.

    Keynes understood this problem (which Robertson dubbed “the long-period problem of saving”) both implicitly and explicitly. He analyzed it throughout the General Theory, and he saw clearly that it could not be solved through monetary policy alone. He also saw that it could not be solved in the long run (even if inequality were completely eliminated) simply by running fiscal deficits.
    ( )

    It seems quite clear to me that it does not bode well for the future if mainstream economists continue to offer only abstract solutions to the problems we face today that attempt to deal with them indirectly while ignoring what Keynes had to say about the long-period problem of saving in Chapter 24 of The General Theory of Employment, Interest, and Money. To deal with this problem rationally we need concrete solutions that attempt to deal with this problem directly.
    ( and )

    1. George, Krugman, Kocherlakota, and Summers, all fear the bond shortage. But their solution is for the US to go into greater debt, and the main beneficiary is Wall Street. Bonds are not just safe, to Wall Street, they are gold to Wall Street. Therefore, the government should get something in return for more deficit spending, like a Tobin Tax on transactions. Wall Street gets the benefits of doing nothing, while main street continues to suffer.

      Hoarding of bonds for structured finance is the real issue, and it drives yields down. It distorts supply and demand. There may be a lot more betting than when Keynes was around, although I am not certain about that. I just know that bonds as collateral for derivatives has exploded, and Krugman wants us to spend, spend, spend, promising prosperity:

  3. "The Fed's treasury holdings have not changed, but the stock of marketable treasuries has grown."

    If this is true, then they are still buying (if for nothing else than to replace matured assets).

    Which means I stand by my claim that all of the evidence indicates that major U.S. money center banks remain functionally insolvent (though one hopes "extend and pretend" has transformed into "fake it until you make it"), since otherwise the Fed should be selling their securities to unwind those Emergency positions.

  4. Sorting bananas...convert the SOMA portfolio into ten-year equivalents, divide by GDP, subtract the steady-state SOMA portfolio that backs currency in circulation into ten-year equivalents divided by GDP. That should tell you the duration-stock withdrawal of QE, which is then thought to depress term premium, not nominal yields (relative to the counterfactual, it should increase nominal yields). Variance of nominal yields is much more a function of variance in policy expectations (i.e. the real economy) than it is the variance of term premium (at least a well specified model, which most are not).

    Last point, "safe asset shortage" seems to confuse a symptom with a cause. Yields are low because of a deficiency of demand (and regulation, which is endogenous). That shortfall of demand drives an excess of savings to investment and increases risk aversion, driving down both the expected path of policy and the term premium.

    Now to address that pile of sour grapes...

  5. Nothing personally, they aren't unwinding QE, they are liquidating debt. This is what is pushing pressure on interest rates. Yet real rates are quite quite low due to this function.

    My guess they end this "phase" of debt liquidation by the end of the year, causing nominal interest rates to rise. The fact financial firms can keep "business as normal" while this liquidation goes on is indeed a great sign of the recovery in financial markets and the liquidation will help them going forward in the future.

  6. I really wish we'd stop paying interest on reserves.

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