The U.S. Federal Reserve Stops Its Music But the Beat Goes On

Canadian mortgage borrowers breathed a sigh of relief last week when the U.S. Federal Reserve ended the third round of its quantitative easing (QE) programs and the world did not come crashing down. Given that our economies are so tightly linked, and given that there is a very high correlation between U.S. and Canadian bond-yield movements, there is always a lingering fear that a sneeze south of the 49^th parallel might give Canadians a case of pneumonia.

Last week reminded me of one of Bob Farrell’s ten rules of investing: “When all the experts and forecasts agree – something else is going to happen.”

Case in point: Most experts have been predicting that we would see financial-market chaos when the U.S. Fed ended QE3.

This was a perfectly reasonable assumption. QE3 was designed to act like a monetary-policy steroid for U.S. financial markets. The Fed used QE3 to buy huge quantities of longer-dated U.S. treasuries and mortgage-backed securities in order to suppress long-term U.S. interest rates, and all of that extra liquidity was also intended to push equity-market values and hard-asset prices to higher levels. When these powerful forms of monetary-policy support were ultimately withdrawn, bond yields and asset prices were expected to decline to their more normal valuation ranges.

There was also precedent to support the view that the end of QE3 would cause major turbulence. When Ben Bernanke first hinted that the Fed might start to taper its QE programs in the summer of 2013, U.S. bond yields spiked and financial markets tanked. He hastily back tracked on his comment, and calm was restored, but only after he gave repeated reassurances that the Fed’s liquidity punch bowl would stay full for a long time yet.

All of this begs the question: When the Fed announced the end of QE3 last week, why did financial markets barely seem to notice?

Let’s examine the specific fears that people had over the Fed’s QE withdrawal, and outline the factors that have thus far mitigated these once widely perceived risks.

Fear #1 – The end of QE3 would cause a spike in U.S. interest rates

While the Fed is no longer using QE3 to buy longer-dated U.S. treasuries and mortgage-backed securities, there has been plenty of other large-scale demand to take up the slack. Newly issued U.S. treasuries are still being sopped up by other central banks, notably the Banks of Japan and China (via Brussels), by U.S. intergovernmental agencies such as the U.S. Social Security Trust Fund, and by massive pension funds, mutual funds and banks. That’s because in today’s market there are few viable alternatives to U.S. treasury debt, with its optimal combination of safety and liquidity characteristics, and this essentially forces these large institutional investors to buy U.S. treasuries regardless of their microscopic yield levels.

The scale of ongoing demand from these large buyer groups was not anticipated by those who feared that U.S. bond yields would have to rise in order to attract sufficient demand to fill the void left by the Fed’s QE withdrawal.

In other words, the unusually high level of demand for U.S. treasuries continues to insulate their yields from natural market forces – which effectively postpones their day of reckoning. For now.

Fear #2 – The end of QE would trigger a global sell-off in equity markets and in hard assets.

When newly created money floods into the global financial system, equity and asset prices rise because the supply of money increases while the pool of available investments remains unchanged – a simple case of supply and demand being out of balance. Also, as demand pushes security prices higher, returns fall and investors are forced to take on increased risk if they wish to maintain the same level of profit. Market watchers have long predicted (and feared) that there would be a rush to unload investments that are most sensitive to the ‘hot money’ flowing from the Fed when it turned off its liquidity tap, particularly in emerging-market economies.

But then a funny thing happened last week after the Fed announced that it would completely unwind its QE3 programs. The Bank of Japan announced it will expand its QE programs by injecting the equivalent of up to $700 billion (US) into the global economy on an annualized basis and there is also speculation that either the European Central Bank and/or the Bank of China will soon embark on its own forms of quantitative easing. So while investors didn’t rush for the exits in response to the Fed’s QE wind down, that’s because this withdrawal is being offset by massive liquidity injections into global financial markets by Japan, at present, and likely by other countries, in future.

It’s as though investors are playing a game of musical chairs – except that every time one country’s song is about to stop, another country starts playing their own version of the same tune. Since the beat of more liquidity never stops, no one is left without a seat. Yet.

Fear #3 – QE3 would fuel significantly higher inflation.

Many market watchers expected that the Fed’s QE programs would trigger higher inflation, which hasn’t happened in large part because most of the additional money that has been injected into the U.S. financial system is not actively circulating throughout the economy (I’ll get into why in a future post). This is often referred to as “the velocity of money” and right now it is at an all-time low in the U.S.

The theory was that higher inflation would eventually force the Fed to raise its short-term policy rate, which, by association, would then push all U.S. interest rates higher. Those increased rates would raise borrowing costs for consumers, businesses and governments alike, triggering huge losses in debt securities as today’s ultra-low yields on fixed-income investments were repriced. All of this would create a powerful headwind for U.S. economic momentum. Sharply higher rates would also increase the risk of bursting credit bubbles, particularly in U.S. student loans and sub-prime auto loans, categories which, although garnering scant press coverage, have both expanded to record levels of debt outstanding.

Overall U.S. inflation remains benign, rising at 1.4% on a year-over-year basis over the most recent twelve months (ending in September). This data point marks the 29^th consecutive month that U.S. inflation has come in under the Fed’s 2% target and that allows the Fed to continue reassuring markets that its short-term policy rate will remain at 0% for a “considerable period”. That means that there is no real pressure being created at the short-end of the yield curve that would exert upward pressure on longer-term bond yields and mortgage rates.

I believe, however, that the fundamental rules of the game, like the law of gravity, have not changed – it’s just that a powerful combination of temporary forces has given the Fed some extra time. But how much time exactly?

Five-year Government of Canada bond yields rose four basis points last week, closing at 1.54% on Friday. Five-year fixed-rate mortgages remain in the 2.79% to 2.89% range, and five-year fixed-rate pre-approvals are offered at 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.

The Bottom Line: Over the short-term, it has been reassuring that the Fed’s QE withdrawal has not triggered widespread financial-market sell offs and general market panic. But over the longer term, I expect confidence to wane as investors come to realize that the combination of forces that prevented an adverse market reaction to the Fed’s QE withdrawal appear just as unsustainable as QE3 was. Sooner or later this game of musical chairs has to stop, and when it does, we’ll see how many seats are left.