August 2017 – Monthly Commentary
On August 2 the Treasury Borrowing Advisory Committee (TBAC) released, via the U.S. Treasury Department website, its roadmap for reducing the Federal Reserve’s balance sheet. The TBAC is a liaison of senior members of money center banks and investment firms and the Treasury Department. The goal of the group is to keep the Treasury informed as to the thinking of the largest buyers of U.S. Government debt. Typically, the group focuses on supply and demand trends and the appetite for Treasury bills, notes, and bonds, and other matters concerning government debt. But the most recent report was much more surprising in that it laid out a plan for how the Federal Reserve is expected to unwind the roughly $4.5 trillion in Treasury bonds and Mortgage-backed securities the Fed has bought over the years.
The first expectation that surprised us was that the TBAC would view a reduction of Treasury holdings to $1.7 trillion from the current $2.5 trillion as a return to normalization. We had anticipated a balance sheet of well below $1 trillion.
The second surprise was that as the mortgage-backed securities mature, the proceeds would be reinvested into Treasury Bills. In doing so, the Fed would reduce their MBS holdings at a faster pace than they’d be reducing their Treasury holdings. Nevertheless, to invest maturity proceeds in Bills is continued quantitative easing, and arguably irresponsible monetary policy. The group did not offer insight as to how long they expected the bill reinvestment to continue.
The third surprise was that the group anticipates that once the Fed reaches its normalized balance sheet, the Central Bank will reinvest maturing Treasuries on a pro-rata basis across the yield curve in the amount of $100 to $200 billion per year. As with the reinvestment of MBS into Treasury bills, this is not normalization but continued quantitative easing.
The fourth eyebrow raising item, not so much of a surprise as a revelation, was the expectation for budget deficits in the near term. The TBAC expects that the U.S. Government budget deficit will again rise above $1 trillion by 2020. That’s nearly double the official administration forecast and represents a sizeable amount of additional bonds that will need to be absorbed by the market. Of course, if the government plans to continue to print dollars to buy a portion of that debt, the burden is eased somewhat.
After reading the 42 page report which offers a degree of granularity that has not been detailed by the Federal Reserve, the obvious question is what impact will the expectations have on the market if they come to pass? The TBAC delineated those risks in three tidy parts. Part one is where we currently find ourselves; declining bond risk premium, with a corresponding decline in credit spreads, reflective of investors reach for yield in a low interest rate environment. Part two forecasts a partial reversal of part one, and envisions that a small increase in yield could result in an accelerating rise of risk premium. Part three is described as simply “Let markets clear.” The group anticipates that under this scenario a meaningful decline in risk assets would occur but that it wouldn’t pose a systemic problem. We assume that by systemic risk the group is referring to banks and given the build-up in Tier 1 capital and on-going stress testing, they would probably be right. But given the trillions of dollars that have been plowed into every sector of the bond market and the lofty valuations in the stock market, investors would likely take a massive hit. Those investors, many of whom are rapidly approaching retirement, would instantly pull back spending, and with that, pose a high likelihood of tipping the economy into recession. Of course the Fed could save us from a deep recession by cutting interest rates sharply as they have done in past recessions. The only problem is that they can’t follow their traditional playbook because there is only one percentage point between the current rate and zero. Alternatively, they could again crank up quantitative easing, except that they’re still engaged in quantitative easing and to accelerate the program would be to expand their already growing balance sheet at an even faster rate. The Fed has backed monetary policy into a corner and the Wall Street elite, as represented on the TBAC, have illustrated that in their most recent report. Only they don’t want to offend the Fed and suggest that when they let markets clear that it won’t be systemic. It may not be systemic, but you can bet your bottom dollar that it will be painful.