Some thoughts to ponder before the Bank of England’s much-anticipated QE announcement later on Thursday.
FT Alphaville has worried before about what might happen once the Federal Reserve ends its $1.25 trillion buying-spree of mortgage-backed securities (MBS). The central bank is due to stop buying MBS in March, when it ends its quantitative easing (QE) is scheduled to end.
Marc Ostwald, of Monument Securities, picks up the thread in a late Wednesday note.
The below three charts are particularly instructive, click to enlarge:
The first chart shows what Ostwald calls “the artificially low level” of spreads between US 30-year mortgage rates and US 30-year Treasuries. This is the effect of QE and those MBS-purchases, which you can see in the second chart.
But even as the central bank tapers off its MBS-purchasing, it’s still snapping up about $12bn every couple of weeks; which suggests that when it finally does end its buying-spree, the exit might come as a shock.
The third chart is the really important one. As Ostwald puts it:
Firstly, at $9.213 trillion (end Q3) the US mortgage related securities market is still significantly bigger than the US Treasury market, and at £1.4 Trillion, the Fed’s Agency MBS purchases amount to 15% of total market size. Last but not least, if there is no clarification of the position of Fannie Mae and Freddie Mac in the not too distant future . . . [and if financial institutions do not step into the mortgage market because of] the inability of banks to make markets due to solvency/balance sheet considerations is all too plain to observe [we have to ask] what happens when the Fed withdraws as a buyer of Agency debt? Do we honestly think that bank balance sheets can step in to the breach, or will we merely have to step into the bright lights of the lack of liquidity, which central bank asset purchases and liquidity operations have allowed us to ignore.
Trading volumes in US debt, Ostwald notes, are still relatively anemic as you can see from the below:
The point then, is that for all that QE-injected liquidity, there’s no clear entity that will step into the breach once the Federal Reserve withdraws its extraordinary stimulatory policies.
And it’s not just a US issue. Back to Ostwald:
This is not just about the Fed. Most acutely (i.e. [today]), this is about the Bank of England’s QE purchases which have robbed so much liquidity from the Gilt market that neither banks or funds are able to pre-empt the change in demand for cash (for Govt debt sales), because of the withdrawal of so much ‘free float’ stock from the Gilt market.
. . . The European Central Bank is no saint in this respect either, for while it has created short-term liquidity by taking illiquid / hard to trade assets off bank balance sheets, and given cash to invest in govt bonds (and any other assets, which applies also to the Fed and BoE purchases) this is borrowed money, which is in effect “locked up”, and as such the assets that have been purchased will have to be sold or exchanged for shorter-term, less risky assets as the long-term refinancing operations get ever shorter (even if the actual drain of actual cash liquidity is minimal).
We may have to wait for the ‘fat lady to sing’ given the above considerations, but markets are not going to be happy places as a consequence, particularly as these asset purchases and liquidity operations may have done more damage than good to the so-called ‘pre-emptive’ functions of markets (even if that pre-empting has often proven with time to be ill judged).
So, again, central bank policy has almost had a crowding-out effect for markets. When the central banks step away, it could be that no one will actually be able to fill the (massive) void, given the above considerations.
On that note, here’s something we noticed on Thursday.
From Structured Finance News:
Fannie Mae and Freddie Mac will not become large buyers of MBS this year and will maintain plans to reduce their total asset size, according to a new letter from their regulator.
Federal Housing Finance Agency (FHFA) director Ed DeMarco told banking committee leaders on Capitol Hill that the Obama administration wants Fannie and Freddie to concentrate on conserving assets while minimizing credit losses and stressing foreclosure prevention.
Related links:
Of vacuums and central bank policies – FT Alphaville
Is negative convexity the new Bernanke conundrum? – FT Alphaville
Could UK money supply collapse post-QE? – FT Alphaville