The Fed: QE With a (Reverse) Twist

At 10 a.m Friday the ISM  report came out, and it was very disappointing. Fed Governor Christopher Waller almost immediately thereafter revealed significant potential policy changes during the 2024 U.S. Monetary Policy Forum in New York.

Gold rallied and gave nothing back…

Waller wants the Fed to completely divest its agency MBS holdings, citing their slow runoff thus far. Next, he strongly advocated for a strategic shift in the Fed's Treasury holdings towards a greater allocation in shorter-dated Treasury securities, moving away from the long-dated focus that has dominated since the Global Financial Crisis.

The dollar softened and did not bounce…

This proposed realignment, aiming to mirror the federal funds rate more closely, suggests a potential 'Operation Reverse-Twist' strategy. This approach would not only impact short-term yields (lower) and the yield curve (steeper with back end yields rising) but also (not?) coincidentally align with the Treasury's plans to increase shorter-term bill issuance. The Treasury and the Fed would match up in the marketplace.

10 Year Bond Yields dropped…

Waller's remarks signal a change in monetary policy right as the Fed's BTFP facility is scheduled to end *and* the RRP piggy bank currently being used to buy Treasuries issued goes empty. Fancy that!

Stocks reacted bearishly to the data but likely took cues from other markets and rallied…

The rest of this document describes the Fed’s logic and intentions in considering this plan of action in current context as well as longer term implications for investors. It also very briefly touches on what could go wrong and how they could respond to an Operation Reverse Twist not having its desired effect.

Bitcoin started doing its “ I’m mirroring stocks” thing again while Oil rallied and then faded…

Most markets digested this immediately in combination with the weaker PMI (manufacturing is still shrinking despite all the Fiscal spending) as a capitulation of sorts and a resumption of QE. Or in the very least, a step towards terminating QT.

What Did Waller Say Exactly?

Fed Governor Chris Waller made the following two points while giving a speech at the 2024 US Monetary Policy Forum in NYC. He started speaking at 10:15 a.m. The speech was in large part his commentary on a recent Fed Paper titled "Quantitative Tightening around the Globe: What Have We Learned?"

His first point was to firmly call for Fed balance sheet reduction in longer-dated Mortgage backed securities

Thinking about longer-term issues related to the Fed's portfolio, I want to mention two things. First, I would like to see the Fed's agency MBS holdings go to zero. Agency MBS holdings have been slow to run off the portfolio, at a recent monthly average of about $15 billion, because the underlying mortgages have very low interest rates and prepayments are quite small. I believe it is important to see a continued reduction in these holdings

Bottom line to point one: He wants the Fed to sell out all the Mortgage Backed Bonds they bought during QE. These were at the lower end of interest costs to the Fed, but greatly delayed in maturity.

 

His second point was to have the Fed then purchase shorter-dated treasuries as a replacement of sorts for the newly sold longer-dated MBS bonds.

Second, I would like to see a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities. Prior to the Global Financial Crisis, we held approximately one-third of our portfolio in Treasury bills. Today, bills are less than 5 percent of our Treasury holdings and less than 3 percent of our total securities holdings… This approach could also assist a future asset purchase program because we could let the short-term securities roll off the portfolio and not increase the balance sheet.

Restating point two: He wants the Fed to buy shorter-dated securities, increasing their shorter duration portfolio maturity substantively. He also feels the housing market no longer needs training wheels to operate.

The Macro Effects of This Policy Should Be…

If that were all that was being done the effect would be to eventually drive longer term interest rates higher while pushing shorter-term interest rates lower. Think of the yield curve as a see-saw shifting.

The economic effect would drive mortgage rates higher and remove economic liquidity there but add liquidity back by also reinjecting that money in the form of shorter-dated treasury purchases. The economy (ostensibly) would have the same amount of money in it, but the Fed has lowered the duration of its debt obligations if not the actual money it pays in interest. It also has helped banks, set the table for debt monetization, and also started the process of getting new long-term government debt ( that the world won’t buy) to be soaked up by the private sector. 1

Resteepen Yields

Put another way; The Fed wants the Yield curve to steepen more with some desired effects. Yield curve steepenings help the bank revenue model. Timely since BTFP ends and banks do better when they make more money on mortgages than they pay depositers), the longer term inflation prospects will be quelled (more on that in a bit), but liquidity will still be present for shorter dated activities.

QE or Not QE

Whether this is QE or not (technically) is not obvious to us. It likely depends on if they are taking money out net-net or putting money in net-net. Bond guys who crunch the numbers will know better. That answer may simply depend on if they are buying more notional bonds than they are selling or not. But there is one thing we know it is not. It is definitely *not* QT.

We all know how much they have to sell in MBS. What we don’t know is how much and at what time they may buy yet. It puts discretion back in the Fed’s and the Treasury’s hands to be abused or managed properly. It certainly smells like a more controlled takedown of the USD. Like checking the brakes on an old train you know may lose control. But that’s admittedly above our pay grade.

But there is more. He’s helping Yellen.

Buying What Yellen is Selling

We know why the Fed is selling its long duration portfolio out. Waller made that pretty clear. But why are they swapping those for shorter dated USTs?

Here’s why. The Treasury has alot more debt to sell into the market to finance its increasingly dominant fiscal spending. it also recently announced an increase to Treasury Bills it will need to sell into the market to achieve this.

The Plan…

Yellen and Co. want the lion’s share of those issues to be in shorter-dated bonds which will constantly rollover and renew. The naked effect of that would be two-fold.

First, the new supply (in a free market) would drive up shorter-term rates. But short term interest rates are not determined by the free market. They are determined by the Fed Funds rate. So, the rates of these shorter-term bonds will be much less volatile and trade closer to Fed funds. So what happens? Well, that “managed” interest-rate risk—which is artificially kept down—manifests in a weaker dollar.

Continues...