Tapering IS Quantitative Tightening
Don't believe the Fed's masterful redefinition of monetary tightening. It's designed to deceive and mislead
Just like with interest rate adjustments, the only easing or tightening an economy and market feels in regards to bond buying is the change in policy.
The current quantum of bond buying does not provide any further easing, only a further increase will provide more easing. This process is exactly the same as each cut in short term interest rates.
Popular opinion confuses monetary policy that might be too easy with further easing. The distinction is vital as it may mean that investors ignore risks as a result of the tapering of bond buying.
If you are in markets you have seen the chart below. It is the most (mis)used chart in market commentary over the last 10 years or so, allowing lazy analysts to point to central banks as the singular cause for equity market exuberance and difficult-to-explain growth stock multiples.
It might be the best chart for understanding why correlation doesn’t equal causation, but does little for explaining why asset prices have skyrocketed.
Since the belief that growing balance sheets have caused the rise in stock prices, it must follow that the market would be terrified of balance sheets that are contracting in size. This is how we get to the fear of Quantitative Tightening (QT).
Most of the market conflates QT with contraction in central banks’ balance sheets by either not reinvesting maturities of government bonds, or by outright selling them. Based on this, we are not currently in QT, but are just ‘tapering’ bond purchases, and since they are still purchasing bonds, we are still in an ‘easing’ environment.
This is absolute rubbish. Quantitative Tightening has already started, and it is irrelevant whether a central banks balance sheet is expanding or contracting to whether we are in the tightening or easing part of a monetary cycle.
This misleading view arises from some clever propaganda by central banks (with the Fed being the main culprit). The propaganda and subsequent mislabelling of the word ‘tightening’ is masterful. It has allowed the introduction of the much softer word ‘tapering’ to be used to describe the reduction in purchases.
If the consensus is that we are still easing then there is little reason to worry about equities, or to offer bonds across the curve. The status quo is kept intact despite the clear fact that monetary accommodation is reducing.
Just like with the advent of ‘forward guidance’ by Janet Yellen in which the Fed offered its assurance to the market that rates would stay long forever to encourage risk taking, the use of the word ‘tapering’ by Jay Powell has, for now, allowed to market to be more comfortable around the shift in policy.
After more than a decade and nearly $25 trillion in bond buying across the big 4 central banks, several central banks have mulled the sale of the bonds that have accumulated on their balance sheets. With the fear of contraction and the lack of political will to bother going through with it, I don’t think it will ever happen.
This means that by the Fed’s and the market’s definition of ‘QT’, it will never arrive. But beware, the tightening of monetary policy has already begun.
QE is still part of the monetary cycle
Before the balance sheet became the primary tool for monetary easing, central banks used to rely on shifting short-term interest rates to effectively set the ‘price’ for money.
From this anchor, the longer end of the yield curve would adjust to what the market’s view of what interest rates would end up being over a longer period. This, in turn, affects other assets that are priced from longer term interest rates such as property, infrastructure and stocks. It also affects interest payments (immediately for floating rate debt, over a longer period for fixed), with a reduction in interest rates reducing expenses for those in debt and reducing income for lenders.
These effects combine to increase wealth and provide a boost to the economy. For this reason, lowering interest rates is an act of easing financial conditions, and hiking interest rates an act of tightening financial conditions.
Of course, central banks shouldn’t be shifting monetary policy to support growth but should be doing it to balance the risks to inflation. In modern times the line between these two things has blurred significantly.
Each individual move in interest rates causes an easing or tightening of monetary conditions. This is a relative designation. It is generally accepted that this is the case.
Some people may say that rates are too ‘easy’ or too ‘tight’ at any point in time. This view, however, is purely subjective. To say that a short-term interest rate of 1% is too tight or too easy for a given economy would require reference to an unlimited number of economic indicators to justify that position. It may be too easy as inflation may be running too hot, but what happens if economic growth is faltering as well?
Similarly, if interest rates were, say, ‘too easy’ for a given situation then all that is being said is that there is too much accommodation afforded by lower interest rates. This accommodation is ongoing, as rates are too low and too much credit is being created or excess cash-flow from interest payments is being saved.
So why is the process of bond buying inherent in Quantitative Easing considered to be easing if there is just an unchanged, ongoing amount of accommodation being afforded to the economy? There is no conceptual difference between interest rates being at a static level and bond buying being at a static level. They are one in the same.
Economists have attempted to answer the question of what role monetary policy and other monetary phenomena have on the economy. Their work has culminated in the ‘Financial Conditions Index’, which tries to explain the role of monetary factors in subsequent economic growth.
The Financial Conditions Index
The Financial Conditions Index (FCI) or Monetary Conditions Index (MCI) is an econometric process that gained popularity in the early 90’s as a way for central banks to gauge how ‘easy’ or ‘tight’ current economic policy settings are.
Nearly every central bank has its own version of an index, with the most followed being the Chicago Fed NFCI and Goldman Sach’s Financial Condition Index. Each is constructed differently, but all share a similar aim. They attempt to explain how financial conditions affect the impulse to GDP growth.
If financial conditions are ‘easy’ then the FCI should correlate with a positive boost to on GDP. The reverse is also true. The economy will probably grow regardless, so the most important information is how much extra stimulus is the easing providing. This boost, or the change in the change in GDP, is the most important statistic to explain.
The indexes take different factors, but most of them have some commonality. They use a mixture of measures that describe financial health (such as credit spreads and volatility measures), surveys and other measures about the availability of credit and measures that paint a picture about the status of the interbank markets. They tend not to take in direct measures of monetary policy (although this gets clouded a little with QE).
Since these indices tend to take in market measures such as credit spreads in addition to factors under the control of central banks, monetary policy effectively needs to offset changes in financial conditions from market disruptions, for example.
What these indices have in common is that, with the exception of credit spread measures which are mean-reverting and don’t trend, they only consider the change in a factor rather than the outright level. This is because a change in an indicator is more meaningful to determining the impulse to growth. In other words, an indicator in a steady state has already had its effect on the economy. Something needs to change to effect it further.
The list of 105 factors used in the Chicago Fed’s model are overwhelmingly biased towards calculating the change in the factor, with the only exceptions being those related to measuring market spreads.
This gets us back to the relevance to considering just the increase in the Fed’s balance sheet because of QE and whether it’s important to financial conditions, or even markets as a whole. On the surface it may seem like considering the change in the Fed’s balance sheet would be the right thing to do given that other indicators do just that. And if you were to include the Fed’s balance sheet in an FCI, considering the change would also be the right thing to do.
Where the problem lies is that an FCI, through its construction, will then consider how the change in the Fed’s balance sheet then correlates with the impulse of GDP. Another way to think of this is that a variable that has a constant change every week or month is never going to correlate with anything else that goes and down, and therefore will provide zero information in helping you to under why the target goes up and down.
Credit spreads are powerful as a factor in an FCI precisely because when they move higher, GDP usually moves down, so they help explain that. The top 10 factors in the NFCI are mostly related to cost of credit and volatility because they are the most useful measures when considering the future effect on the economy. “Money Stock” is included as a factor, but has little weight.
The only times a factor like the size of the Fed’s balance sheet will be useful is when there is a change in rate of growth. As long as its growing (or shrinking) at a constant rate, it will be of no help to predict any future effect on the economy or asset prices, no matter what a simple overlay chart suggests.
Information theory in markets
Information theory in markets suggests that publicly available information will be immediately incorporated into market pricing. A recent paper in the Review of Financial Studies has determined in 2015 that the effect of publicly available information on US stock prices to explain ~40% of performance, with privately available information being the second largest effect at ~30%. Noise had a smaller share, around 20%.
‘Information’ in this sense refers to a piece of knowledge that changes the future path of a company. This can also include the eradication of a downside case, like the change of losing a large contract, for example. They all represent a deviation from the average of all possible outcomes as priced by the market at the point in time before the information is available. They represent a change in the steady state.
The amount of profit doesn’t matter. What matters is the change in the profit outlook. The paper above confirms that point.
Macro markets trade in a similar manner. This can be seen every day as the large share of economic data that prints close to consensus has little effect on market pricing. It’s only when a data print surprises to the upside or downside when market pricing shifts.
The same applies to considering the increase in the Fed’s balance sheet. If it is buying at $100bn a month, then when it buys $100bn a month it will have no effect on market pricing, and no subsequent effect on GDP growth, or asset pricing.
Why the QT label is entirely incorrect
This is counterintuitive, and against what I would say the majority of the market thinks. How could a $100bn NOT have an ongoing effect on asset prices? Well it doesn’t. It just happens to be that keeping rates at zero and buying $100bn of bonds a month might very well be a level that is far too easy for the current state of the economy. With large fiscal deficits and other credit still growing, there is likely no need for this steady state of monetary policy.
The NFCI has said the same, and has said this for the last 30 or so years. The chart below gives the NFCI and its component parts. A value below zero indicates that economic conditions are too ‘easy’ and a value above zero ‘too tight’. Financial conditions, according to the NFCI, have been too easy since the early 90s.
Why have equity markets rallied? Well they always have, well before QE. This bull market isn’t that extraordinary in nominal terms. In a real sense the numbers get closer, but they still don’t put the current bull market in first place.
The Fed’s definition of QT implies that there is some magical event that occurs between the point of buying $10bn of bonds and selling $10bn of bonds per month. There isn’t. The economy won’t know the difference, and the change will be exactly the same as it was from moving buying from $40bn a month to $20bn a month. It’s just $20bn less. Therefore there is no difference in effect of growing versus shrinking the balance sheet, only the change it takes to get to that point.
Will balance sheet reduction actually happen?
Putting an increase in the Fed’s balance sheet up against rising equity prices is simplifying cause and effect the most that you possibly could. The Fed has capitalised on this to convince the market that ‘tapering’ of Quantitative Easing is not tightening. This is not true, and this form of jawboning is just a new tool in an ever expanding tool bag.
Like forward guidance before it, all QE does is convince the market that accommodative policy is here and it will stay for a long period of time. Plain and simple. The actual act of buying is less important than delivering on the promise that easy financial conditions are here to stay.
SocGen has developed a chart (below) which summarises how tapering is tightening through the mechanism of calculation of a ‘shadow policy rate’. The ‘shadow rate’ calculates the effect of easing or tightening through QR in terms of traditional interest rate movements. GFC QE tapering is illustrated as an effective 3% tightening in monetary policy, as you would expect. Monetary accommodation is being taken away from the economy. Whether the balance sheet shrinks or not is irrelevant. All that matters is that the Fed decided to buy less, and nothing more.
What is interesting is that during this tightening the NFCI actually fell even more into the ‘easy’ territory than before. This just shows that not enough tightening was done to offset the improvement in all the financial indicators used in the series, and more should’ve been done to tighten financial conditions to bring the environment back to neutral.
For those worried that balance sheet contraction will be a reality, don’t. There is no political will to do it, let alone any capacity for the market to accept it. The politicians get their deficits funded, and the market gets low volatility and increasing asset prices from having accommodative policy. Everyone is happy. A reduction to zero buying is probably the limit of what they can achieve before the market really gets upset. This isn’t because the balance sheet is shrinking, as explained. It’s just the same as lifting rates past some arbitrary psychological barrier.
The equivalent for the ECB might be going back through the zero interest rate mark. Nobody thinks this will be an issue, but apparently shrinking the balance sheet is. This is inconsistent.
The other giveaway that the balance sheet won’t reduce in size is that interest rates are being raised before this will even get close to happening. Shrinking buying of bonds is equivalent to interest rate hikes, so if they are hiking interest rates they have less plans to contract buying to the point where they are selling. It’s one or the other, and the Fed has already made that choice.
This is all happening because, like a spoiled petulant child, the market will throw its toys out of the pram when it doesn’t get what it wants. But, like any spoiled child, they are entirely the creation of the parents that were meant to bring them up with discipline. The Fed has lacked any discipline for the last 30 years, and has given the market everything it wants. It’s no surprise that the Fed has to play with definitions of tightening and easing to stop the market from puking. But that is where we are.
For the meantime, don’t concentrate on balance sheet reduction at all. It’s not important, as the tightening that’s happening now is more than sufficient to worry about.