We should start with this assumption: the market is smarter and faster than you. Prices almost always discount "before" what will happen next. I totally agree with you and the whole content of the article, very nice.
Nice piece, but why does everyone who explains how QE works continue to use the pension fund example? All it does is perpetuate the narrative that the CB is "printing money...they're printing money" as Mike Norman loves to parrot?
I have been asking for 2 years now, why would a pension fund 'sell' a bond to the CB only to then have to go looking to "buy" a bond? Why sell it in the first place? I've also been asking, with no clear answer, how does one tell how much bond buying by the CB is actually from non-banks?
Wouldn't it be closer to reality if when explanting QE we used banks as the other party to whom the CB is buying bonds from?
Hi Dingo! I've used banks as the counterpart many times in other articles :)
The answer to your question is simple: the Central Bank goes out and buys bonds from primary dealers, which always (always!) find a clearing price to onboard these bonds from banks/pension funds/asset managers such that they can sell to the Central Bank.
It's an imperative: when the Central Bank does QE, it (must) swap the asset side composition of the private sector.
The question (to me, at least) is what happens if bank reserves drop due to corporate Treasuries/depositors re-balancing their assets. Agree that they're doing well for the moment - but does this continue as their trad business base shrinks? p.s. Thanx for the thoughtful answers to everyone's questions.
Alfonso, would you agree that the pace of QT will depend on...
1) whether supply-side disruptions (and inflation) improve organically during 2022. If they dont, the Fed will be forced to be more aggressive with their QT / rate hikes.
2) the DXY levels: if the dollar keeps stregthening, the Fed wont be able to be too aggressive with its QT / rate hikes.
Hi Hector! 1) is definitely very important, as they want to be seen as fighting inflationary pressures that are eroding the real purchasing power of Americans for now >1y
why would private sector banks by USTs at 2% if CPI is at 7%. Just think if CPI lands back at 3-4% then you got to see UST rise. so i have a feeling negative real rates in the US are here to stay
Money market participants care more about what would happen on the next day more than about the next 10 yrs.
They have to manage cash flow in/out daily.
They buy high quality & liquid bonds (but low yield) because... what else can they do? It's simply the reality of economic condition is still too risky to them. In this kind of risk averse environment, liquidity preference is usually high.
Besides, banks operate on Leverage, as the nature of the business. Borrowing cheap money via repo from money market, or even with the Fed to fund Treasury securities position.
And also with it, facing less regulator's requirements.
Fantastic article, as usual! It seems to me that the process you're talking about should shift institutional portfolios back towards bonds relative to equities, and that should compress equity multiples. While that's not a bad thing in the big picture, with the quantity of public equities trading at extremely high multiples, I worry a soft landing for the economy (the Fed's priority) may not be so soft for public equities.
Excellent write-up. My issue is that we don’t know what level causes disruption in asset markets. But with more leverage, it probably takes less to cause it. Just look at mortgage rates: The minute they’re above the level of the previous two years, housing demand stalls markedly. Add in the fact that refinancings have already gone to zero by then, and the economy decelerates very quickly.
If real wages have not increased much and you make borrowing more expensive (higher real interest rates), it's a virtual certainty demand for mortgages will slow down indeed.
I think that we can be very certain that level will be significantly higher than pre COVID. It will be interesting to see how fast will financial conditions degrade and how FED will answer, considering political fight around inflation in election year .
Alf, when the bank is buying the bonds from the Fed (QT) are they acting as a dealer/market maker, or is there a dealer in between the Fed and the banks?
Superb analysis.. ty for sharing
Glad you liked it!
Superb analysis.. ty for sharing
We should start with this assumption: the market is smarter and faster than you. Prices almost always discount "before" what will happen next. I totally agree with you and the whole content of the article, very nice.
Nice piece, but why does everyone who explains how QE works continue to use the pension fund example? All it does is perpetuate the narrative that the CB is "printing money...they're printing money" as Mike Norman loves to parrot?
I have been asking for 2 years now, why would a pension fund 'sell' a bond to the CB only to then have to go looking to "buy" a bond? Why sell it in the first place? I've also been asking, with no clear answer, how does one tell how much bond buying by the CB is actually from non-banks?
Wouldn't it be closer to reality if when explanting QE we used banks as the other party to whom the CB is buying bonds from?
Hi Dingo! I've used banks as the counterpart many times in other articles :)
The answer to your question is simple: the Central Bank goes out and buys bonds from primary dealers, which always (always!) find a clearing price to onboard these bonds from banks/pension funds/asset managers such that they can sell to the Central Bank.
It's an imperative: when the Central Bank does QE, it (must) swap the asset side composition of the private sector.
There is always a clearing price for everything.
None of this seems very good for U.S. bank stocks. How much of an impact (if any) do you see? p.s. great analytic work; much appreciated.
Financials are doing very well as yields have repriced up, but at this stage it wouldn't be one of my favorite stock market sectors.
The question (to me, at least) is what happens if bank reserves drop due to corporate Treasuries/depositors re-balancing their assets. Agree that they're doing well for the moment - but does this continue as their trad business base shrinks? p.s. Thanx for the thoughtful answers to everyone's questions.
Alfonso, would you agree that the pace of QT will depend on...
1) whether supply-side disruptions (and inflation) improve organically during 2022. If they dont, the Fed will be forced to be more aggressive with their QT / rate hikes.
2) the DXY levels: if the dollar keeps stregthening, the Fed wont be able to be too aggressive with its QT / rate hikes.
Opinions? Thanks a lot!
Hi Hector! 1) is definitely very important, as they want to be seen as fighting inflationary pressures that are eroding the real purchasing power of Americans for now >1y
thanks for this. Yes I remember that the RRP has $1.9T in there or so, so it can be deployed.
Correct
thanks! very clear.
Welcome!
Thanks adding the podcast to the blog post
My pleasure, happy it helps!
Thanks. It's very clear the analysis and your love for the matter
why would private sector banks by USTs at 2% if CPI is at 7%. Just think if CPI lands back at 3-4% then you got to see UST rise. so i have a feeling negative real rates in the US are here to stay
Banks are forced to buy bonds due to heavy regulation, and also to hedge interest rate risk on their balance sheet.
Money market participants care more about what would happen on the next day more than about the next 10 yrs.
They have to manage cash flow in/out daily.
They buy high quality & liquid bonds (but low yield) because... what else can they do? It's simply the reality of economic condition is still too risky to them. In this kind of risk averse environment, liquidity preference is usually high.
Besides, banks operate on Leverage, as the nature of the business. Borrowing cheap money via repo from money market, or even with the Fed to fund Treasury securities position.
And also with it, facing less regulator's requirements.
Thank you.
Fantastic article, as usual! It seems to me that the process you're talking about should shift institutional portfolios back towards bonds relative to equities, and that should compress equity multiples. While that's not a bad thing in the big picture, with the quantity of public equities trading at extremely high multiples, I worry a soft landing for the economy (the Fed's priority) may not be so soft for public equities.
This might be the case. But as I pointed out, there are many ''cushions'' the US can use to try and engineer a (market) soft landing too in 2022.
Yes, and thank you for laying that out.
Excellent write-up. My issue is that we don’t know what level causes disruption in asset markets. But with more leverage, it probably takes less to cause it. Just look at mortgage rates: The minute they’re above the level of the previous two years, housing demand stalls markedly. Add in the fact that refinancings have already gone to zero by then, and the economy decelerates very quickly.
If real wages have not increased much and you make borrowing more expensive (higher real interest rates), it's a virtual certainty demand for mortgages will slow down indeed.
I think that we can be very certain that level will be significantly higher than pre COVID. It will be interesting to see how fast will financial conditions degrade and how FED will answer, considering political fight around inflation in election year .
Your work is very much appreciated. Thank you!
Alf, when the bank is buying the bonds from the Fed (QT) are they acting as a dealer/market maker, or is there a dealer in between the Fed and the banks?