What Does The QE Experience Say About Rates In A Shrinking Fed Balance Sheet World?

Authored by Bryce Coward via Knowledge Leaders Capital blog,

The Federal Reserve is likely to decide next week to begin letting assets roll of its balance sheet as bonds mature, instead of reinvesting the proceeds.

This means that the balance sheet will begin to shrink in size and other market participants will be forced to absorb the supply of new issuance of treasury and mortgage backed securities. Conventional analysis of supply and demand dynamics might suggest the exiting of a large marginal buyer of these securities would cause yields to rise to some higher equilibrium level, but the QE experience suggests something else entirely.

When the Fed was engaged in asset purchases and the rate of change in the Fed’s balance sheet was rising (late 2010, mid 2012 through early 2013) long-term treasury yields rose on the back of juiced growth and inflation expectations produced by the stimulus. When the rate of change in the Fed’s balance sheet would flat line or fall (most of 2010, most of 2013 through 2014) treasury yields fell on the back of subdued growth and inflation expectations. Importantly, it was both real rates (TIPS) and breakeven inflation that followed this pattern, which is indicative of the level of economic stimulus produced by QE.

Chart 1 below shows 10-year nominal rates (red line, right axis) overlaid on the three month difference in the Fed’s balance sheet (blue line, left axis).

Chart 2 below shows 10-year real rates (red line, right axis) overlaid on the three month difference in the Fed’s balance sheet (blue line, left axis).

Chart 3 below shows 10-year implied breakeven inflation expectations (red line, right axis) overlaid on the three month difference in the Fed’s balance sheet (blue line, left axis).

But all that is history.

The question now is what will happen to rates as the Fed begins to unwind its balance sheet. Is there a reason to believe that inflation and growth expectations will rise as the Fed tightens policy?

In other words, is there reason to believe rates will act differently during the unwind than they did during the wind? We think the same economic mechanisms that were in place between 2009-2014 are still in place today and that long rates are likely to move lower as the Fed tightens policy via a smaller balance sheet.

Steen Jakobsen On The Next 30 Years: "Everything Is Deflationary"

Authored by Mike Shedlock via MishTalk.com,

Steen Jakobsen, Saxo Bank chief economist and CIO just pinged me with a PowerPoint presentation on the preceding and next 30 years.

He commented “I somehow to my own surprise came to one single trend I believe in: everything is deflationary. Enjoy the “funny pictures” and the outlook.”

30 Years Ago

Current and Foreward Trends

Mish Comments

I agree with Steen that the trends are deflationary from a CPI perspective.

Compare the GMO 7-Year returns estimate to the John Bogle view. I believe GMO has this correct.

Public pensions are in serious trouble even on the more optimistic view.

Credit Impulse

Pay close attention to the global credit impulse chart. Credit impulse is the “Rate of Change of Change” of global credit creation/QE.

The Stevens Report discusses the topic in Why “Credit Impulse” Matters to You.

There are many analysts and investors who believe that the entire ’09-’17 stock rally is nothing more than the result of a historic, globally coordinated credit creation event from the world’s major central banks. Put in layman’s terms, every major central bank in the world has done QE at some stage over the past eight years, and pumped the world full on cash. So, all they’ve done is create massive asset inflation in bonds, stocks and real estate.

While there is no hard proof that this global expansion of credit has powered US (and now global) stocks higher, there certainly is at least a casual relationship if we look at history.

The reason I am pointing this out is simple: There are growing signs that the near-decade-long global credit creation/QE cycle appears to be nearing the end. First, there are the central bank actions. The Fed is hiking rates, and likely taking steps to reduce its balance sheet, draining liquidity from the system.

Second, the ECB appears to be on the verge of tapering its QE program, and while that will still result in a net credit increase for the next year, the pace of credit creation will slow. Finally, and perhaps most importantly, China continues to aggressively reduce credit in its economy, and I’ll again remind everyone the last time they did that, we got the volatility in 2H ’15.

This is where the “Credit Impulse” comes in.

Credit Impulse is a term used by various research firms that measures the “Rate of Change of Change” of global credit creation/QE. Put simply, while the global amount of credit may still be rising, the pace of the increase has not only slowed… it’s turned negative. Similar to taking your foot off the gas while you’re still going forward. It’s just a matter of time until you stop.

Getting more granular, UBS has been out front on this issue, and back in February noted that Credit Impulse turned negative. In a much-anticipated report out last week, the firm said that the decline over the past three-to-four months has accelerated, with Credit Impulse dropping to -0.6% annualized over the past three months.

Now, Credit Impulse is a composite of various measures of credit, including loans, loan demand, and other metrics, so this is not a hard-and-fast number. And the fact that it has turned negative doesn’t mean we’re looking at an impending collapse in stocks.

But if we look at the entire picture, negative Credit Impulse; a more-hawkish-than-expected Fed that’s apparently committed to reducing its balance sheet, a Chinese central bank that is apparently committed to reducing credit in that economy, and an ECB that will begin tapering QE in 2018… the fact is we appear to be nearing the end of the post-financial-crisis credit expansion, and with economic growth where it is, I cannot see how that will be positive for stocks longer term.

Bottom line, I’m not turning into ZeroHedge (although they are all over this), but the fact is that I sense a lot of complacency regarding the end of this global credit creation cycle.

Credit Impulse Update

Also consider comments on the Global Credit Impulse by Adam Tooze.

In late Feb 2017, UBS’ analyst Arend Kapteyn reported that a measure of global credit impulse covering 77% of the world economy was behaving rather alarmingly. After growing vigorously in 2015 and 2016 thanks to another round of Chinese stimulus the credit impulse had collapsed to zero.

Since then the news is worse with the global credit impulse indicator falling earlier this month to negative numbers not seen since the dot.com bubble burst. This should be a strong leading indicator of a fall in investment and contractionary pressures in the world economy.

Wrapping up the global credit impulse, ZeroHedge discussed it in Why The (Collapsing) Global Credit Impulse Is All That Matters: Citi Explains.

Complete Powerpoint

Once again Steen made an excellent presentation. It consists of 28 slides. I used 14 of them.

Click on Investment Returns Plus/Minus 30 Years for Steen’s full presentation at the 30th Anniversary CFA Annual Forecast Event, Singapore July, 2017.

Thanks, Steen!

20 Trillion in Government Debt Means No Lifeline for Caterpillar`s Declining Revenues

By EconMatters

The real problem for Caterpillar is that China is no longer going to build a new city every month, the commodity super cycles are over for a long time given the global debt overhang, and don`t expect Trump Infrastructure Projects to save the day for CAT, as the United States has its own debt problems to worry about which is unsustainable even at these levels.

We basically have gone from 8 Trillion to 20 Trillion in Government Debt since 2008, and it is the rate of change of this debt spending that is the real elephant in the room, and we are just coming up on the entitlement`s impact curve on our government debt obligations.

I feel for Trump because he has inherited a boxed in economic situation here, he actually wants to stimulate the economy through growth projects; but the previous wars, financial crisis, bailouts, and unwise and inefficient spending programs have made borrowing anymore money at these levels impossible, and Congress knows this fact!

They may try to go down this borrow and spending road but it will backfire bigtime on the Republicans. By my calculation the Democrats are going to benefit immensely from the fact that the shit is going to hit the fan during the Trump presidency and Republican controlled Congress from past bad governmental practices of what I call "Can-Kicking" and "Short Termism."

Trump has no hope of avoiding a recession, and things are going to get quite nasty with an exploding Debt problem, a Central Bank out of Bullets, a Crashing Financial Market, and the end of the current business cycle. We borrowed a lot from the future with short term solutions to problems we faced, and now it is time to pay the Debt Piper!

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Uber Has Too Much Debt For IPO (Video)

By EconMatters

We discuss Uber`s massive debt which we estimate around 4 to 4.5 Billion in aggregate, with a total capital raise of 11 Billion. The total debt number is astounding to say the least, but it is the rate of change of the debt number that is mindboggling. I don`t believe Uber has the Financials to go public, and investors risk losing everything at this rate of cash burn over the next three years. Uber may be the biggest high profile startup to file for bankruptcy before they make it to the IPO exit for the payoff for investors.

Uber has a spending problem, reminds me of Napster, quite a disruptor but not a profitable business model, flawed wasted energy, that becomes totally irrelevant and obsolete in five years anyway. Uber is essentially a glorified Ponzi scheme if you really get right down to the crux of the finances of this company. There are going to be sizable losses for all the investors valuing this company at a 62.5 Billion Valuation. That number will mean diddly squat in bankruptcy court!  

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