Dear Valued Clients and Friends,
Like most of you, before the financial crisis, I had never heard the term or uttered the term “quantitative easing.” This somehow becomes completely standard fare in the lexicon of finance in the last 13 years, and it is now uttered by people who I am 1,000% positive do not know what it is dozens of times per day in the media. There is nothing wrong with not understanding the obscure vocabulary of monetary economics unless of course, you are sitting around using the obscure vocabulary of monetary economics. But words have meaning, and today we’ll look at some of these words.
But we will do more than define words today. After all, you deserve to get your money’s worth for what you pay for this Dividend Cafe subscription!
My goal today is to walk you through the history of quantitative easing, explain what policy goal it is serving, what policy goals it is not serving, and what it means to you as an investor. By the time you are done with this read, I believe you will be a QE expert. And I assure you, as a fellow QE expert, nothing makes you more popular at parties than knowing the deep dive of quantitative easing! It’s a good thing I’m married …
Okay, QE and why you should care, in this week’s Dividend Cafe!
History thou doth repeat itself
The first bout of “quantitative easing” our country experienced was in the immediate aftermath of the Great Financial Crisis (GFC), and we now retroactively call it QE1. I have pointed out the obvious several times over the years, but at the time we did not call it QE1 because we had no idea there would be a QE2, or QE3, or QE4, etc.
But this first batch of quantitative easing – whereas, as a policy tool to stimulate the economy, the Fed began buying Treasury bonds and Mortgage bonds from banks with new money – lasted from March of 2009 through March of 2010. Now, I am hyper-sensitive to the post-hoc fallacy, especially when there were so many other things going on at the time that I believe warrant consideration as factors, but the market bottomed in March 2009, just as QE1 began.
One year later, the market was up over 3,000 points, which from a percentage standpoint, was massive. March 2009 through March of 201o saw the Dow go from ~7,000 to ~10,000, a roughly +43% gain in that time period. But again, there was also a market bottom at the beginning of this to consider, and there was the introduction of TALF in March 2009 where the Fed clarified that they would be buying a host of asset-backed securities to “unclog” the financial system. And of course, some form of profit recovery began in the marketplace (later in that year). And there was the repeal of FASB 157 that eliminated onerous mark-to-market issues that were limiting the financial companies’ ability to breathe.
But what if we didn’t use the Dow to evaluate this period? What if we looked at the yield curve? The spread between the 2-year Treasury and the 10-year Treasury was 200 basis points at the beginning of QE1. By the end, the curve had widened to 280 basis points – a healthy curve steepening that I would do anything for right now (well, almost anything).
A few months after QE1 ended, the curve had tightened back to 230 basis points. So let’s repeat here:
- 2% spread between the 2-year and the 10-year in bond yields as QE1 begins
- A 2.8% spread by the time it is done
- A 2.3% spread a few months after it has ended
Now, we get to QE2. We think we are done with QE throughout the summer of 2010. The Dow is 10,500 in March 2010, and it doesn’t move for five months. It comes down a bit (there was the Flash Crash day in there somewhere), but it really doesn’t move much at all and gets to the end of summer 2010 just below 10,000. The Fed hints at a QE2 in late August 2010 and begins the bond-buying of QE2 in November. The yield curve once again had started just below 2% and got to 2.9% a few months later. When QE2 ended in June 2011 the spread was 270 basis points, and a few months later it was down to 167 points. So let’s repeat here:
- 1.9% spread between the 2-year & the 10-year in bond yields as QE2 begins
- A 2.7% spread by the time it is done
- A 1.7% spread a few months after it has ended
Then there was QE3, the big daddy of them all. The 2/10 spread was 150 basis points when the program began in September of 2012. By the end of the bond-buying expansion, spreads were 259 basis points. They started to “taper” (slow down the purchases which was not and is not the same as stopping) in December 2013, and they completed this process in October 2014. The 2/10 spread had narrowed to 180 basis points when done. So let’s repeat here:
- 1.5% spread between the 2-year & the 10-year in bond yields as QE3 begins
- A 2.6% spread by the time it is done
- A 1.83% spread a few months after it has ended
The yield curve was dead flat as COVID was starting, and in March of this year, we got as much as 158 basis points wide between the 2-year and the 10-year. As I type it is sitting at 108 basis points (the 2-year is 0.24% and the 10-year is 1.32%). So in four periods of quantitative easing, you have had the yield curve widen after QE began, and in four periods it has tightened either at the point of “talking about tapering” or “actually tapering.”
So what does this mean?
Expectations drive yields (interest rates), not the actual news. Now, the actual news can influence expectations but fundamentally markets price in ahead what they believe is coming. I don’t believe the zero percent federal funds rate is changing any time soon (the short end of the curve which is one input that influences the steepness of the yield curve), but I do believe QE is going to begin coming down. And I’ll say more about that in a moment. But what you have with this tighter yield curve is the long end of the curve coming down (in English, the 10-year has dropped from 1.8% to 1.3% over the last few months). History is repeating itself.
But I said, “what does this mean?”
First, it means the following: The market believes Quantitative Easing will begin to come down later this year. I see no scenario where the Fed suddenly announces they are ceasing altogether. And I think pigs will fly before they announce that they are actually quantitatively tightening in 2021, 2022, or 2023. What THAT means (tightening) is the inverse of quantitative easing. The “easing” is BUYING bonds at the Fed with money that doesn’t exist; “tightening” is selling those same bonds. Now, the only time they “tightened” since the GFC they didn’t actually “sell” anything – they merely stopped reinvesting some of the bond proceeds that matured. You can call that “soft tightening.” I don’t see even “soft tightening” coming for a long time.
But I expect the Fed to announce they are slowing Mortgage Bond purchases later this year (they will likely hint at it sooner than that). And I think into next calendar year (mid-2022?) they will start to phase down Treasury purchases – slowly, very slowly. I do not think he will do that until after he has been re-appointed by President Biden, IF he is re-appointed by President Biden.
What this means is that various uncertainties linger around QE that are not going to be resolved any time soon.
(1) When will mortgage bond purchases be reined in?
(2) At what speed will they be reined in?
(3) When will Treasury tapering be considered?
(4) Once Treasury tapering is considered, how long will it be until it is announced?
(5) Once announced, how long will the tapering last? In other words, when will the QE actually come to an end as opposed to just being slowed?
(6) What will be the rate impact as QE is slowed?
(7) What will the government be spending as QE is slowed, and will the market fund the deficits that spending creates?
(8) Will an emergency happen economically before the QE has come to a stop that requires a re-acceleration of QE?
Now you get it
In the months ahead the discussion of QE will not merely be a hand-wringing matter at the Fed, touched by the political challenges of a Fed head whose term is about to end.
It will not just be a media focus – a media that has 24 hours of a news cycle to fill for their television, print, and cyber audience.
It will also be a piece that has EIGHT variables (on my list alone; I am sure I am missing some) for traders, algos, hedgies, and all sorts of other actors who do not share your financial goals and objectives to have an opinion on, to have a take on, to try and find a way to express in a trade, etc. I can’t say it any simpler than this: There is no reason to believe the play-out of these uncertainties around the “wind-down” of QE (“slow down” probably a better term) will not elevate market volatility, create choppiness, and add to the overall noise that already permeates markets in the months and quarters ahead.
Now you tell me
The risk to emergency policy measures is that they are not very easy to take off when the emergency ends. From low interest rates to government fiscal spending packages to new programs to, yes, quantitative easing, temporary emergency measures become permanent either in structure or expectation very easily.
Maybe I will devote another Dividend Cafe to what they could’ve, should’ve, would’ve done back in the GFC, and back when COVID entered the scene. But I am not interested in critiquing QE at the point of a financial emergency, at least not necessarily. I am merely interested in explaining that keeping QE on long after the moment of financial markets distress has been resolved is challenging, distortive, lingering, and ill-advised.
So here we are.
But does QE have a legitimate function to begin with?
I more and more believe it exists to signal to markets a boldness from a central bank in assisting financial markets – their operations and their efficiency. You can make a case it is a tool for mucking with rates at different points of the term structure as well, but candidly, I think there has been a diminishing return there, too, as markets price around the distortion and price in the expectation of “what comes next.”
Japan began this a long time ago and is still doing it. They own over 60% of their nation’s bond market.
None of us want that to happen to us.
The good, the bad, and the ugly
There is no question that during the moments of heightened, emergency distress, QE (or the announcement of QE) has helped the calm financial markets. I don’t believe even that can come or has come without a cost, but as trade-offs go, the emergency use measure in the emergency use moment must be adjudicated separately from what I am writing about now.
What I believe can be universally agreed to about QE is that:
(a) It has not contributed to organic economic growth in any meaningful or material way
(b) It is not led to increased bank lending
(c) It has not led to consumer or corporate borrowing
(d) The inclusion of mortgage-backed securities in the bond purchases of the post-COVID quantitative easing is certainly not needed to “help” the housing market, which is at dangerous levels of unaffordability now.
*Strategas Research, Daily Macro Brief, July 15, 2021
(e) It has created ambiguity in financial markets as to when it will stop, when it will go away, when it will come back, when it will be used, what it is used for, what its objectives are, and what its exit strategy is.
A reminder before my conclusion
For context of the next section, please remember David’s Law 14 and David’s Law 22 provided here as a reminder (numbering made up on the spot):
- Equities are always and forever, eventually priced as a discounted reflection of earnings. Everything else is noise. Eventually.
- What creates volatility in markets is more uncertainty than it is bad news. Markets have a miraculous way of pricing bad news. They have a very difficult time pricing uncertain news.
These two laws form the presuppositions behind my conclusion.
A Contrarian View – and the Right One
I believe that when one has an opinion on a subject, they should believe it is the right opinion. However, if one believes their opinion to be wrong, I think they ought to consider changing their opinion. Therefore, when I state I have an opinion on something, I do also believe that the opinion I have is the right one, otherwise, I would stop holding that opinion. Let me know if this logic is hard to follow.
So it is with a humble conviction that I state a view contrary to consensus:
If and when the Fed backs off of Quantitative Easing, if they provide the market the missing clarity of when, what, how, and why, the elevated volatility such a tapering will create will be reserved for traders, and ultimately markets will benefit – perhaps substantially – by the elimination of a current uncertainty looming over markets.
Note what I did not say – that there will be no volatility. There certainly will be, though I think in both the rates market and the equity markets it will all be much different than the taper tantrum affair of 2013. But nevertheless, regardless of volatility, I think markets hate uncertainty, and QE is one big giant ball of uncertainty. Some tapering off this policy tool, best reserved for severe financial markets emergencies, that comes with deeply needed clarity, would be a benefit to markets and to economic fundamentals.
Chart of the Week
While so many focus on ways to manipulate the economy around its cyclical challenges and realities, I cannot help but notice the screaming opportunity for organic growth that transcends the need for manipulation. The average age of non-residential assets (machinery, property, plants, equipment, factories) is the highest it has been since 1964. Companies don’t need a lower cost of capital to be motivated to invest in their own productivity; their need to invest just to replace is screaming enough! There is plenty of capital, plenty of liquidity, and plenty of reason to invest in a CAPEX renaissance.
So what do you think is holding businesses back? (that is meant to be rhetorical)
*Strategas Research, Daily Macro Brief, July 8, 2021
Quote of the Week
“Never confuse brains with a bull market.”
~ Humphrey B. Neill
* * *
I would bookmark this issue of Dividend Cafe. The QE discussion is not going away, and the short-term noise around it all will be tempting to play into in the weeks, months, quarters ahead. May this Dividend Cafe be our memorialized policy position on the subject.
And may the next emergency that arises – because there is always another emergency – present a policy apparatus that actually has options, not one where the emergency tools were exhausted in a non-emergency.
I know not what tapering awaits government bond purchases, but I do know what we will not be tapering at the Bahnsen Group:
The growing dividends of a properly managed equity portfolio. That is the truly taper-free zone.
To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet