Roubini Global Economics

Originally published in the June 2011 issue

Rewind to June 2010, and recall the fragile state of the global economy: the Eurozone Crisis was erupting, and had caused a worldwide panic, with corporate bond issuance grinding to a halt. Concerns of a US double-dip were growing, and along with it the chance that deflation would spread from countries like Latvia and Ireland to the rest of the Eurozone and the US, making life hellish for already over-indebted households and governments.

While we shouldn’t give all the credit to monetary policy, since July of last year there been a remarkable improvement in the equity market, a huge decline in expected risk, a compression in investment-grade (IG) and high-yield (HY) credit spreads, dollar depreciation and, perhaps most importantly, a bottoming out of inflation expectations. The most obvious beneficiary of the policy, Treasury yields, have been clouded by other factors, but rates remain low and (because of the rise in inflation break-evens) real rates are rock-bottom.

Now that QE2 is ending, will all those developments unwind, proving to be just a liquidity-driven mirage? Has the Fed intervened too heavily, disrupting normal market functioning, printing money to subsidize a spendthrift, out-of-control government. In short: No, and No.

Hardwired for survival
Humans are creatures of habit, with elements of neophobia hard-wired in our brains that are most-likely survival mechanisms from our cavemen days. Yet at the same time homo sapiens is the ne plus ultra of innovators, even if some inventions (h-bombs and subprime CDOs, to name a couple) might do more harm than good.

In the field of monetary policy, the speed and depth of the recession that followed the financial crisis led many central banks to cut rates to near-zero and create a bewildering blizzard of new liquidity measures that may well have avoided a second Great Depression. But most developed market economies were by and large still failing to recover much. This called for further innovation, because conventional monetary policy – essentially, buying T-bills until short-rates get to the central bank’s target – could do no more; most so-called Taylor rules using output gaps and inflation indicated the target rate should have been deep in negative territory (see, for example, Papell’s overview).1

So the Fed followed in the footsteps of the Bank of Japan in the 1990s and bought longer-term government securities and other bonds; given the experience in Japan, one would think this step was hardly radical. Yet this seemingly minor extension of normal monetary rate cuts has been criticized and scrutinized to a degree that a series of a few 25 basis-point rate cuts never would, and its imminent end (for now) has caused misgivings. Yet once we get past our neophobia and look at the facts, it’s plain to see that QE2 has been a modest success and that the end of the Fed’s buying won’t create market mayhem.

A $600 billion question
The six hundred billion dollar question is, will there be a sudden tightening of monetary policy after the Fed’s last auction to purchase Treasuries under the current programme in June? We at RGE don’t think so. Given the stock of purchases was already known, the end of QE2 should be fully priced in, and we do not expect the event to have much impact on the economy or markets. Neither the end of QE1 in March 2010 nor the less-expected end of large scale asset purchases or LSAPs by the Bank of England in December 2009 had any disruptive effect in the rates markets, anywhere on the US or UK yield curve or in other asset markets.

In other words, it appears that what matters is more the quantity of bonds purchased and the bloated size and composition of the central bank’s balance sheet – the stock – rather than the speed, or flow of such buying or selling. There are a slew of academic papers that support this, and RGE has reviewed these in detail in “Beyond the End of QE2”.

In the April 2011 press conference, Bernanke indicated that the reinvestment of runoff on the Fed’s mortgage backed securities portfolio will be maintained beyond June; thus, the end of QE2 will not lead—for the time being—to a reduction of the balance sheet of the Fed. On the way to unwinding policy easing, the Fed will be cautious in announcing an end to the reinvestment of MBS runoffs or other maturities. Though the Fed won’t immediately reverse course and sell back the $600 billion it just bought, given the size of the US fiscal deficit, it won’t take long before the Treasury dumps a similar amount back into investors’ portfolios.

Crowding out worries overblown
But fears of Treasury prices falling off a cliff are unfounded: again, going back to the period between QE1 and QE2 shows that there was ample appetite from households and other domestic sources now that the US savings rate is significantly positive, along with foreign private investors seeking a safe haven and Asian and Middle Eastern central banks following mercantilist trade policies or dirty floating-rate currency regimes. “Crowding out” worries are also overblown, as the phenomenon of government spending pushing out private investment isn’t a major worry when there is huge slack in the economy, rates are at zero, and corporate bond issuance is setting records.

What should fixed-income investors be focused on post QE2? Three main things: the speed and sustainability of the US recovery, the Fed’s exit strategy – which will be partly determined by the economy, and the appetite of different types of investors to continue to accumulate treasuries and corporate bonds in their desperate search for yield, even as most holdings of equities remain below their pre-crisis levels.

As to the first point, RGE has long argued that the recovery, such as it is, will continue to be sub-par, anaemic, and “feel like a recession” for a long while. Banks and real estate are obviously crippled, but this is a typical characteristic of post-financial crisis experiences illustrated by Rogoff and Reinhart, and of the “balance sheet recession” used to describe Japan by Richard Koo, and the similarities with the US and UK, and Japan today are rife, but still underappreciated by investors and policymakers.

Fed battles deflation
Note that inflation is not a major concern of ours: the Fed’s battle is with disinflation and deflation, and one that it is determined to win. Success, for the Fed, means being able to raise rates to more normal levels: the steep US yield curve indicates investors are quite optimistic, expecting this to occur around 2016. Those who think yields are too low are even more confident in the US economy and the central bank’s ability to avoid the fate of Japan.

As (if?) the economy kicks into a higher gear, normalization of monetary policy will come through two channels: the unwind of the balance sheet, and rate hikes; because the former is also equivalent to tightening, it means rate hikes will be slower and fewer than if LSAPs had never taken place. The Fed previously kept the two tools quite separate: the original balance sheet expansion to over $2 trillion occurred while short rates were still 1%; while Fed funds later went to zero the balance sheet actually contracted.

Moreover, central banks need to be careful that their actions are not too disruptive to financial markets, so selling MBS and Treasuries is likely to be moderate and makeshift – tying rate hikes to asset sales in the manner that Fed governor Plosser recently suggested seems unnecessarily inflexible. This means that rates will be painfully low for a very extended period, as the financial repression of savers and holders of dollars continues, to the benefit of the same banks and overleveraged homeowners that caused the mess. Risk-averse investors should expect to be burned even by low inflation for the next several years. This is also priced into Treasury Inflation Protected Securities or TIPS, which have negative yields extending out many years.

$8 trillion cash hoard

Life is unfair, but complaining won’t change the Fed’s resolve. One of the strangest recent financial phenomena is the massive accumulation of cash by firms and households alike earning next to nothing, which accelerated during the crisis. This hoard now totals 8 trillion dollars’ worth (more if short-term assets besides savings deposits and moneymarket funds are included). Households have recently increased their holdings of US treasuries by some $800 billion, but historically their allocation to this asset class was double the current proportion of their total wealth.

Pension funds and insurance companies are also important buyers, and have been soaking up massive corporate issuance, helping drive down spreads despite the supply.

The main alternative, of course, is to buy more risky, higher yielding assets – which is exactly QE’s aim. Even though foreigners now buy less than half of US issuance, there is no getting around dependence on their continued appetite (See Fig. 1).

Finally, there’s always the option of QE3. These assorted buyers should keep yields and spreads from rising much, and assuming the crippled economies convalesce and that the fiscal and monetary exit policies are successful in restoring debt sustainability, avoiding a dollar crisis and serious credit deterioration, or exiting too quickly and triggering a new recession, as Japan did repeatedly and the Fed nearly did in 2010. Like all investors, buyers of treasuries and other fixed income securities need to have a lot of faith, and even if one believes they’re fairly priced, Treasuries are anything but risk-free.

David Nowakowski is director of credit strategy at Roubini Global Economics. Previously he was a managing director at Atlas Capital Management, a global macro hedge fund focused on emerging markets. He has also worked at the Rohatyn Group, an emerging market hedge fund, as a fixed-income and currency strategist and was a fixed income portfolio manager at Lazard Asset Management.


[2] (Prajakta Bhide, Christian Menegatti, David Nowakowski and Nouriel Roubini, May 2011).