Tapering But Not Tightening

When the Fed announced on December 18, 2013 that it would begin tapering its quantitative easing (QE) programs by $10 billion/month starting in January, financial markets seemed to breathe a sigh of relief. To the surprise of many, the S&P actually rallied on the news.

In reality, the Fed had no choice. QE has reached the point where it may well be doing more harm than good (and some would argue that it passed that point a long time ago). Instead of bolstering market confidence, QE was heightening fear on many levels.

Here are some examples of how this has been happening:

• When QE was allowed to roll on, unabated, month after month, it was widely interpreted as a sign that the U.S. economy was in very bad shape. Why else, people reasoned, would we still need this kind of radical financial-market intervention? Perpetual QE was reducing the confidence-building benefit that some recent positive U.S. economic data would have otherwise fostered. Illustrating a phrase from Ralph Waldo Emerson, the Fed’s QE actions spoke so loudly that the markets couldn’t hear anything else that it was trying to say.
• QE is expanding the Fed’s balance sheet at a staggering rate, bloating it to $4 trillion in December. This is dampening confidence as consumers, investors and businesses alike worry about how this massive overhang will one day be unwound. Everyone intuitively understands the old adage about the bigger they are, the harder they fall.
• The Fed’s QE programs continue to fuel asset bubbles and to risk destabilizing the global financial system. For example, if you’re a U.S. bank with unfettered access to ultra-cheap money, would you rather earn paltry returns through traditional lending or use your balance sheet to leverage your cash into more speculative investments, as so many of your competitors are doing? The Fed had to show markets that it was committed to reducing the size of its QE programs to stop investors from basing their investment decisions on the belief that QE would continue, unchecked, in perpetuity.

What many people still don’t understand is that when the Fed reduces its QE programs by $10 billion this month, it won’t actually be tightening monetary policy.

By way of explanation, let’s start with a description of the current situation.

Simply put, the U.S. federal government spends more than it takes in. To fund this gap between revenue and spending, which is commonly referred to as the budget deficit, the U.S. Treasury issues debt to borrow the difference.

In normal times, the U.S. treasury would sell this debt in the open market and the cost of doing so, the interest on that debt, would be determined by the balance between the amount of debt issued and investor demand. If the federal government issues more debt than investors want to buy, then the interest rate on this newly issued debt would rise until demand increases and a supply/demand balance is achieved. If the U.S. treasury issues less debt than investors have an appetite for, the interest rate would fall until demand decreases to meet supply.

But these are not normal times.

Today, newly issued U.S. treasury debt is not subject to market forces. Instead, the Fed is buying most of the new debt that is issued by the U.S. treasury. This is commonly referred to as “monetization”, and normally it doesn’t take too long before this tactic, especially on the scale that it is now occurring, triggers significantly higher borrowing rates. But the U.S. federal government can get away with this practice for much longer than any other country because the U.S. dollar is the world’s reserve currency. (This brief explanation warrants a longer explanation in a future post.)

Despite its many recent challenges in reaching a comprehensive agreement on fiscal policy, due to its use of a blunt budget instrument known as sequestration, the U.S. federal government has managed to shrink its deficit (the annual shortfall that gets added to the total debt). This means that the U.S. Treasury doesn’t have to issue as much new debt to cover the U.S. federal government’s current shortfall. And since the Fed buys just about all of the U.S. Treasury’s new debt issuances, a shrinking federal government deficit allows the Fed to reduce, or taper, its monthly purchases without altering its overall support of U.S. treasuries. The same is true if there are reduced issuances of mortgage-backed securities, which is the other type of debt that is being supported by the Fed’s monthly QE purchases.

Thus, while the U.S. Fed will buy $10 billion less debt in January, it is not tightening monetary policy by doing so. Put another way, since there will be less debt for the U.S. Fed to buy next month, the Fed would actually have been loosening its monetary policy further if it hadn’t reduced its bond-buying programs and adjusted to the reduced debt requirements of the U.S. Treasury. Until the recent comparatively small $10 billion announcement, the use of the word taper had been associated with a rush for the exits. But because the $10 billion tapering did not actually result in a tightening of monetary policy (as explained  above), the much more important test, when the Fed actually does tighten monetary policy, is  yet to come. I will save my personal sigh of relief until the markets absorb that larger challenge.

Five-year Government of Canada (GoC) bond yields have risen by thirteen basis points since my last post in mid-December, closing at 1.94% on Friday. Five-year fixed mortgage rates are beginning to move higher in response so anyone who is in the market for a fixed-rate mortgage should lock in a fixed rate immediately.

I expect a lot of volatility for our fixed-mortgage rates in 2014 because our GoC bond yields move in lock step with U.S. bond yields, and both are expected to remain at today’s ultra-low levels for only as long as the Fed remains the marginal buyer of U.S. treasuries and mortgage-backed securities. Any talk of additional stimulus withdrawal by the U.S. Fed could easily cause bond yields to spike around the world.

Variable rates are still offered at prime minus 0.55%, which works out to 2.45% using today’s prime rate of 3.00%. While variable rates are not expected to rise for a long time yet, I still think that variable-rate holders will have their courage tested in 2014.

On first glance, this prediction might seem to contradict my thought that variable rates would not rise for quite some time. After all, Bank of Canada Governor Poloz recently estimated that it will take two years before our inflation rate returns to the Bank’s 2% target, and the U.S .Fed is forecasting that it will keep its equivalent Fed funds rate unchanged until at least the end of 2015. Those are soothing words from the people with their hands on our variable-rate pricing levers.

But that is only part of the picture.  The challenge for variable-rate borrowers will come if and when our fixed rates surge higher, as I expect they well may in 2014’s QE-taper dominated world. When that happens, variable-rate borrowers will become increasingly nervous as the rate for their fixed-rate conversion option rises. It is this increase in the cost of variable-rate borrowers’  emergency parachutes that will test their courage.

(Side note: The Big Five banks know how to scratch an itch when they see it. If you’re a variable-rate borrower with the Big Five and fixed rates rise sharply, expect a call or letter from your bank that encourages you to lock into the safety of a fixed rate “while you still can”. Those borrowers who worked with an independent mortgage planner when setting up their original loan, however, are well advised to circle back with them before converting to the banker’s favourite mortgage.)

The Bottom Line: I think that 2014 will be dominated by speculation over decisions about when and by how much the U.S. Fed will taper its quantitative easing programs. Interestingly, whenever the Fed has talked about tapering, it has also attempted to minimize any negative market reaction by announcing that it is pushing the timing of its next short-term rate increase farther into the future. As such, I think that fixed-rate borrowers will be reaching for their Tums a lot more often than variable-rate borrowers in the year to come.