The Eventual Unwinding Of QE: Why It’s Ignored And What It Could Mean

The Eventual Unwinding Of QE: Why It’s Ignored And What It Could Mean2012, in many ways, has been fairly uneventful thus far consisting of a seemingly endless grind up in the equity markets and a range bound US Treasury market.  The most vocal arguments involve whether stocks are “overbought”, will Apple eclipse $500bil in market cap, and predicting the size of the latest Euro-zone LTRO.  In other market segments that I so often comment on, real yields evaporated as institutions moved out the risk spectrum in search of yield.  Leveraged loans, non-agency MBS, CMBS, and Muni’s have all simultaneously been among the “flavors of the year”.

The onslaught of positive economic data has been consistent and undeniable to even the most bearish sell-side analysts.  Despite this welcome news, many participants point to inflation, which is below the Fed’s target, and stagnant wages as arguments for why a QE3 could still be on the horizon.  Many scoffed at such chatter, however real money backed up this thesis.  Since late 2011, Agency MBS (the obvious target of future QE) ceased being directional with US Treasury rates and instead grinded tighter hitting record highs in terms of current coupon MBS prices.  Noted bond manager Bill Gross increased his exposure to Agency MBS to a staggering 50% of the $250bil PIMCO Total Return Fund.  Such a directional bet with risk/reward seemingly unfavorably skewed was peculiar but screamed one thing: a bet on future QE.

Today’s market felt altogether different for a myriad of reasons.  Two major assets had dramatic selloffs in what looked like seconds/minutes.  The 10yr UST yield jumped almost 10bps instantly in anticipation of Ben Bernanke’s testimony to Congress.  Later (and news to nobody at this point), Gold dropped over $60 dollars and ended down more than 3%.   Stocks fell, bonds fell, commodities fell. The one sentence explanation for why most people feel this happened? Bernanke didn’t mention QE.

I posed a question earlier that asked “What would happen to the economy/markets if the Fed gradually sells down their entire Agency MBS portfolio over the next year?”. This would obviously be the removal of well over $1T in Agency MBS. Would such a directive send such a shock to the system that it would make today’s moves in QE sensitive assets look mild?

One consequence of removing so much liquidity would be the removal of excess reserves.  As shown in this Fed paper, “The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiatives and in no way reflects the initiatives’ effects on bank lending.”  Overnight money would suddenly be in a lot more demand.  Would it go so far as to cause banks to need to pay interest to keep deposits?

More important for most market participants is what would happen to asset prices at large.  If QE was a support for asset prices, what would happen if it was fully drained? Many previous buyers of Agency MBS have balked at buying a 30yr MBS at a 2.75% yield. The removal of the Fed as a buyer would surely push mortgage rates up. Extrapolating this thought all the way down the risk chain would apparently push buyers into the next safest asset, not the next riskiest.  High Yield, Non-Agency MBS, CMBS and the like may not be necessary if said investor can achieve his risk/reward in Agency MBS and/or IG Corporates.  With rising mortgage rates would a feeble housing market face damaging headwinds in the form of lower affordability?

Would the US Dollar see a dramatic rise?  Would the gold bugs be squashed?  My thought in this post is NOT to suggest that the Fed will soon (or ever) wind down their MBS holdings, but rather plant the thought of what the consequences would be.  I clearly don’t have all the answers.  What would the faction of investors who decry QE as “money printing” call the selling of these MBS?  ”Money burning?”.

The markets appear very narrow in their thought process right now, and in my opinion have no clue what the implications would be of this Fed science experiment.  While it may not be a question that needs to be answered today, tomorrow, or this year – it eventually will need to be answered.  Like a young child who is anxious to cross the street and needs to be reminded by his/her parents to look both ways, is the market being a little too directional and only looking one way?