Select Language

Search

Hotel QE Forever - Monthly Roundtable

FICC Podcasts April 06, 2021
FICC Podcasts April 06, 2021

 

Margaret Kerins along with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Ben Reitzes, Dan Belton and Ben Jeffery from BMO’s FICC Macro Strategy team bring you their debate on the impact of the massive fiscal and monetary policy regime changes underway and whether or not Global Central Banks will ever actually be able to extricate themselves from the market and what this implies for US and Canadian rates, high quality spreads and foreign exchange.


Follow us on Apple Podcasts, Google Podcasts, Stitcher and Spotify or your preferred podcast provider.


About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

Podcast Disclaimer

Read more

Margaret Kerins:

This is Macro Horizons monthly episode 26, Hotel QE Forever presented by BMO capital markets. I'm your host Margaret Kerins here with Ian Lyngen, Greg Anderson, Stephen Gallo, Dan Krieter, Ben Reitzes, Dan Belton and Ben Jeffery from our FICC Macro Strategy team to bring you our debate on the impact of the massive fiscal and monetary policy regime changes underway. And whether or not global central banks will ever actually be able to extricate themselves from the market and what this implies for US and Canadian rates, high quality spreads in foreign exchange.

Margaret Kerins:

Each month members from BMO's FICC Macro Strategy team, join me for a round table, focusing on relevant and timely topics that impact our markets. Please feel free to reach out on Bloomberg or email me at Margaret.Karins@bmo.com with questions, comments, or topics you would like to hear more about on future episodes. We value your input and appreciate your ideas and suggestions. Thanks for joining us.

Automated voice:

The views expressed here are those of the participants and not those of BMO capital markets, its affiliates or subsidiaries.

Margaret Kerins:

There are several regime shifts underway. Most notable of course, is the combination of massive global and monetary accommodation and fiscal support and the dependence of global economies and markets on this support. The stimulus began as a bridge to weather the pandemic storm, but it's now shifting into longer term growth initiatives in some economies with potential implications, for improving the structural issues that remain in some of these countries. So this naturally brings up the question of whether this reliance on fiscal and monetary stimulus can actually ever be withdrawn in a fashion that resembles the past?

Ian Lyngen:

I think that there's a short answer to this question, and the answer is no, we have seen it after the last financial crisis and how challenging it was for the Fed to even attempt to normalize monetary policy before we had specific episodes of reserves scarcity. If we look at the experience of the BOJ, as well as the ECB, I think it's safe to assume that the Fed is going to be involved in financial markets for quite some time at this stage, I think the most the Fed can hope for is to not be in a position where they're forced to extend into either different asset classes or a more rapid increase of their balance sheet. In an ideal world, the Fed should be able to slowly move toward tapering in the beginning of 2022, wind down QE and move forward to lift off rate hike at some point.

Ian Lyngen:

I struggle to imagine that they will be within the next five years in a position where they will let the balance sheet organically start to shrink the way that they did toward the end of the last expansion. That said, there's no question that this is an actively debated topic at this point.

Dan Krieter:

I don't think you even have to look at the BOJ. I think you just have to look at what happened to the Fed in 2019. I mean, it's not like the economy was roaring along until COVID arrived. The Fed tried to normalize the balance sheet from 4.5 trillion and they got it down maybe 750 billion at most. And all of a sudden the system started to fall apart. I mean the Fed first cut rates in June, 2019. It just goes to show how dependent financial markets can become on the central bank. And now 4.5 trillion seems like nothing compared to where the balance sheet is now. I have a hard time envisioning not just in the next five years, the Fed really ever being able to meaningfully decrease the size of that balance sheet. And the question for me becomes, what does that mean?

Dan Krieter:

If in 2019, we started to see these cracks appear as the Fed starts to run down their balance sheet, even just a little bit. Are we going to be looking at asset valuations through the context of the size of the Fed's balance sheet in the next say decade?

Ian Lyngen:

Another thing I think it's important to think about in this context is 4.5 trillion in terms of the Fed's balance sheet today. Isn't what it was in 2019, simply because of reserve growth and simply because of the growth of currency in circulation. So while there is some implied sticker shock related to the absolute numbers, the true target of neutrality is a moving one.

Margaret Kerins:

Let's put some numbers on it. The Feds SOMA account now tops $7 trillion, including almost $5 trillion in US Treasuries. The Fed owns 28% of the Treasury coupon market outstanding. And in 2020, the Fed sent 86.9 billion in profits back to the US Treasury as required by the Federal Reserve Act. So putting that into context, total interest payments on Treasury debt, it's over $500 billion and just under a $100 billion of that is being sent back to Treasury from the Federal Reserve. So $7 trillion those are still big numbers, right? In the context of total debt outstanding. You're looking at 28% of the coupon market that is being financed by the fed.

Ian Lyngen:

Well, historically even before the Fed jumped into QE during the last financial crisis, the Fed still owned a reasonable amount of the Treasury market simply through their basic functioning. That said it was nowhere near the levels that it is right now. You make a great observation about the Federal Reserve system, kicking money back to the Treasury department, which in effect, or at least optically might appear to be a reduction of the net interest costs. However, there is potentially an impact associated with that in terms of the valuations of the dollar.

Greg Anderson:

The interesting thing there, Ian is what happens if everybody else is doing the same thing at the same time? Then maybe the dollar doesn't go down or at least it doesn't go down against other currencies. The thing that I would point out though is, well, if people lose faith in money, because they can see that it's just being created so rapidly, they tend to move to something else. One of the first things that people would move to is real estate. And of course, maybe we're seeing the first signs of that already. And maybe that is the factor that ultimately pushes central banks away from such rapid money creation. But I'm sort of in agreement that this is not something that either the Fed or any other central bank is going to back away from quickly. And so we're looking at years before they reach that conclusion.

Margaret Kerins:

And that's part of the one of the regime changes that we've seen with Janet Yellen in the Treasury, basically focusing on the cost of the debt service rather than the total amount of debt relative to GDP, which is a huge, huge regime change.

Ian Lyngen:

I think that's akin, but not directly related to, one of the other regime changes that we've seen the Fed at least attempt to undertake in this cycle. And that is to go from a central bank with a very strong track record of fighting inflation to a central bank, with the potential for a reasonable track record of creating inflation. That's going to be a big regime change for the Fed in the event that they can pull it off. If we look at the Treasury market at this point, what we see with investors point forward rate hikes every time there appears to be an acceleration of growth is a market that is responding to the Fed based on essentially the assumption that we're still in the prior regime, rather than listening to what monetary policy makers are saying in so far as they're going to be willing to accept a moderate amount of inflation above the 2% goal over an extended period of time. There is going to be some type of rationalization between those two views at some point. I doubt, however, that, that will be a 2021 story.

Ben Jeffery:

And Ian, this brings up a major question that I think all of us have been receiving over the past several weeks. And that is how are we going to be wrong in this situation? What is it going to take to see the Fed allowed this market pricing of more aggressive normalization to be brought forward and not push back against the idea that inflation is coming and they will move to offset it? And to me, what jumps out is we will start to need to see a pickup in realized inflation to start to get more in line with some of the lofty expectations that we're seeing both in survey-based measures and in market-based ones. With core CPI at just 0.7% on a three-month annualized basis. I think it's fair to say that we're a long way from an inflation regime or the Fed will start to allow normalization to meaningfully pick up in terms of the market discourse.

Margaret Kerins:

And the regime change surrounding inflation, does have implications possibly for not only for the timing of an eventual liftoff, but for the pace of that liftoff, as we know, inflation typically lags the monetary policy stimulus by six to 12 months. And that implies that the Fed at some point might be behind the inflation curve. And there are implications for market pricing.

Ian Lyngen:

Certainly, especially if we assume that the Fed won't find themselves in a position to respond in the context of their new framework to rise in inflation until the inflation is indisputably in the system. So unlike in the past where the Fed might have managed to forward inflation expectations, waiting for it to be realized, as you point out Margaret puts the Fed decidedly behind the curve and combating it. And so that implies that when they do start moving, that they will have to move more dramatically and potentially to a higher terminal rate. Although I'd argue we're still early enough in the process, and there are material headwinds too, true demand side inflation that we might not ultimately find ourselves in a position where the Fed is scrambling to catch up with the realities of the performance of the economy.

Dan Belton:

Yeah. And Ian with respect to the corporate market, I think if the Fed does find itself behind the curve with respects to inflation, that's one of the greatest risks that we're viewing to credit spreads. The Fed has been the primary reason that corporations have taken on so much debt at such cheap levels. And back to Margaret, your point about secretary Yellen and talking about the difference between the amount of debt to GDP versus debt service costs while it's true, that debt service costs are probably more important today, for the Fed to remove any accommodation because of the emergence of inflation would really result in a significant sell-off in credit spreads because these higher borrowing costs would feed through to corporate profitability. And that could have serious impacts for the corporate market, both in credit spreads and also equities.

Dan Krieter:

Well, I think an important point to make here on this regime changes. Yes, I agree. When compared to previous Fed regimes, this is a regime change. The Fed is telling us they're going to basically be willing to be behind the inflation curve, which ultimately means they may have to react more strongly in future years. But I think another important regime changes. They have a lot more ammo to deal with inflation at this point, and I'm not even referring to faster rate hikes. We talked earlier about the huge summer portfolio, if inflation ever got to be a problem, they could just more actively run down that summer portfolio and pretty quickly stamp out any inflation I would think. So for me, the more concerning thing for the Fed is what if we do all this and inflation doesn't come. I mean, we've talked a lot about the demographic challenges of inflation, and I think technology it's well-covered ground here, but it has a profound dis-inflationary impact. And so for me, the bigger concern, isn't the Fed being behind the inflation curve it's what happens if inflation ultimately doesn't come?

Ian Lyngen:

Well, I'd argue that the Fed has also tried to step in front of what market participants should be anticipating as an important trigger to get monetary policy tightening back on the table. Specifically, the lessons learned from the last financial crisis have shown that the unemployment rate for the low to middle wage earners is key in terms of timing, wage pressures, and subsequently true demand side inflation, which is what the Fed is focused on far more so than any transitory headline increases or base effects comparable to what we'll see over the next three or four months. So when we think about inflation, getting out of control from the Fed's perspective, that presupposes a much tighter labor market than we're likely to see over the course of the next two or three years.

Margaret Kerins:

So Ian, those are some great points. And it brings me back to something that Greg had mentioned earlier, where he said, what happens if everyone else is doing the same thing with regard to central banks and fiscal policy? And one of the themes that is creeping up in the market is the topic of monetary policy divergences globally. And how real are these divergences and what is the implication for the markets?

Greg Anderson:

So Margaret in terms of divergences that we have seen thus far, I'm going to argue that there haven't been any divergences. So everybody went to zero interest rate policy and substantial quantitative easing a year ago. And they have stayed there. Where we're starting to see divergence is markets pricing in rate hikes within two years and in some places. So for example, in the FX swap market, basically 20 basis points of Fed rate hikes priced in one to two years out from now, also in Australian dollar that's priced in and where you might see the divergence is, look, it seems like some central banks are pushing back against pricing and rate hikes anytime near that soon. Certainly the RBA has done that, where the Fed hasn't pushed back as vehemently. These are really small and subtle divergences. The other place where you might see at some point a divergence, although we haven't seen it yet is the ending or the tapering of quantitative easing probably a long ways off, but it's an important divergence. And if somebody were to accelerate or increase QE at this point, that would be an important divergence.

Stephen Gallo:

Yeah. Thanks, Greg. I think one of the things that struck a core with me was your comment about the Fed's path towards tapering. Because I think when you look at some of the vulnerabilities, for example, in portions of the emerging market space, possibly you could throw Europe into the mix. One of the thing that really matters is the extent of the monetary policy surprise in the United States. So to the extent that the Fed surprises markets with hawkishness, or somehow on the path towards normalization, that's where I think there could be problems for some of the more vulnerable portions of EM, possibly even Europe.

Stephen Gallo:

So I think the monetary policy surprise factor matters a great deal. As things currently stand, we expect that the Fed will do its utmost and we'll do a good job telegraphing the normalization process. But if anything gets in the way, which surprises financial markets, that could be a problem for some of the emerging markets, particularly those that have a high exposure to a rise in US interest rates.

Stephen Gallo:

In particular I think one of the things that I've pointed out and we've talked about many times on these recordings, on these podcasts, is the buildup of foreign currency debt since the global financial crisis. And every time we have another situation where the Fed has to be proactive, getting involved, we see that reliance and that buildup of debt increase further. So there are definitely some real vulnerabilities in the global economy. Those vulnerabilities are probably made worse. If for some reason we have a persistent overshoot in inflation, but assuming we don't have that, I absolutely agree with you as the Fed telegraphs, the normalization process, there are some central banks that will probably try to go the other way or to indicate that their path to normalization is going to be delayed relative to the Fed's.

Ian Lyngen:

How much of that do we think is actually based solely on the process out of the pandemic i.e vaccinations efforts toward hard immunity and more a structural issue about the divergence in performance of economies. I think that this does raise an interesting debate for policy makers. Could one use a broader acceptance of different monetary policy regimes at this stage to make up for some of the pre pandemic differences in consumption and inflation.

Stephen Gallo:

What you're suggesting is that there are two elements of the recovery. One is the reopening and the other one is legacy issues. So assuming we see progress towards reopening in a number of economies globally, then the factor that you're left with is the legacy issues. I would just point to China. I mean, there are many, many examples, but China is a great example because it's such an important economy. They're clearly battling with a leverage issue in China, which is why we've seen policy makers in China recently reach for macroprudential levers to slow the pace of leveraged growth. So that is a legacy issue for China. China, is well, and truly ahead of the Western world when it comes to reopening and dealing with the aftereffects of the pandemic, but the legacy issue, which China bowels with is the buildup of leverage. And I think that's why there has been an idiosyncratic macroprudential policy response if you like in China to explain that. So that's one good example. I think

Greg Anderson:

The other bigger legacy issue is diverging what seemed to be natural inflation rates where in the US you're looking at something like a percent and a half inflation seems to be equilibrium at this point, shy of the Fed's 2% target, but only a 0.5% shy. But for Europe, we're looking at what seems to be a natural inflation rate somewhere between a half and 1%. And for Japan, it's probably about zero. As a result of these issues. This is where backing away from extraordinary easing, the market has to assume that the Fed will back away faster than these other central banks if they ever do back away.

Ben Reitzes:

One exception to that Greg, would be Canada where the market is pricing a meaningfully more aggressive bank of Canada than pretty much any other central bank in the world. Tapering is going to come here first, but partially due to technical reasons because the bank of Canada already owns 40% of the government of Canada market. So that has created big problems. And so they do have to pull back there, but the tapering that's likely coming later this month, it's just going to fan those flames even more that the banks is going to be pulling back on stimulus even sooner.

Ben Reitzes:

But going back to Margaret's original question, which is how are central banks going to extricate themselves from all this? I don't see a way the bank Canada will be in the Canada market for the foreseeable future. Even if not providing net stimulus, they'll need to reinvest the proceeds of maturities for almost as far as the eye can see, because government issuance is going to be, even as deficit shrink, maturities are still going to be huge rolling over this pandemic debt. And so the bank will have to consistently be involved. And I don't see how any other central bank in the world it's going to be any different. I guess the hope would be that maybe their share of any individual market kind of whittles away over time, but their involvement is not going to disappear anytime soon,

Ian Lyngen:

An observation that came to mind when Greg made the point about the different inflation rates between Europe and the US actually comes down to a measurement one to some extent, because if we look at the composition of inflation in the US the US includes OER and shelter, whereas Europe, at least on the core side takes it out. And so I think that not only is there a measurement issue, but that also implies a policy divergence that doesn't seem likely to be shifted anytime soon. One of the biggest surprises from my perspective is that we have seen the difference in policy responses occur so quickly during this cycle.

Ian Lyngen:

And it strikes me that that speaks to how quickly we have gone from as a world economy, a massive recession to a reasonably strong recovery. And then we start to see the different paths forward for the individual economies.

Ben Reitzes:

Ian you mentioned all the fiscal stimulus coming into play here and really unprecedented from a global perspective and for most individual countries also unprecedented add to that, the kind of changing work environment that we've seen in most industries. Is it possible that while there are legacy issues and like in Canada, for example, that would be household debt is an issue it's still going to be, but have things perhaps changed sufficiently that some of those legacy problems won't be an issue moving forward. I mean, things have just changed so drastically that perhaps kind of longer-term productivity problems won't be there anymore. And we've kind of entered a new macro regime for the next, whatever, call it 10 to 20 years.

Ian Lyngen:

I could envision a situation over the course of the next two decades where the global economy transitions into a different regime where work from home becomes more of a reality where the fungibility of knowledge industry workers increases. And that ends up being a net dampening impact on wages. Because if you can hire someone in a low cost area who is just as competent as someone in a high cost area, performing the same task, what we'll see is we'll see firms seek to take advantage of that under the guise of it being a benefit to the worker. And it will also serve to keep net employment costs lower. So on one side, yes, this might serve as a massive reset to some extent. However, my interpretation is that what we're seeing is a rather dramatic acceleration of a lot of the trends that were already in place.

Ian Lyngen:

The push towards automation is another obvious one. As you point out Ben, the adoption and embracing of the work from home environment, taking that to the next stage however, this will exaggerate the difference between the upward mobility of high skill, high wage earners, and those that the Fed has emphasized during this cycle, which is the low to medium skill and wage earners. So if anything, I believe that, that pushes out the timeline for the Fed to truly attempt to normalize monetary policy. During this cycle.

Margaret Kerins:

Ian, you had brought up the theme of the process of coming out of the pandemic versus structural issues that pre-existed the pandemic and the implications. And I think this ties in with what Ben was saying. When we look just massive amount of fiscal spending in the US, it's 5.6 trillion with the possibility of an infrastructure program later in a year. And obviously a portion of the fiscal stimulus is to get us through the pandemic period, but there's also the potential for a structural element with longer term implications for the US economy.

Stephen Gallo:

On that point, Margaret, I would just say, maybe I'm going about this too simplistically, but ultimately I think that one way we're going to be able to measure what comes next is how efficiently some governments spend the money or how inefficiently they do it. Because that to me will dictate number one, with what you suggest, if there's going to be a structural change or improvement in potential growth, as a result of the fiscal stimulus and the government involvement, or in a sort of worst case scenario, the money is not spent efficiently. And therefore that leads to much higher taxation, much higher regulation and a very slow growth environment over the medium term.

Stephen Gallo:

I think you could probably start to look at different countries or economic jurisdictions and try to judge which ones are going to more efficiently spend the money than others. And I think that's an important factor to weigh

Margaret Kerins:

Thanks Steven, you bring up some great points on how efficient or inefficient some of the government spending might actually end up being, which is certainly something to keep an eye on. Okay, that's a wrap. Thank you to all of our BMO experts. And thank you for listening. This concludes Macro Horizons monthly episode, 26 Hotel QE Forever. Please reach out to us with feedback and any ideas on topics you'd like us to tackle.

Margaret Kerins:

Thanks for listening to macro horizons, please visit us at bmocm.com/macrohorizons. We'd like to hear what you thought of today's episode. You can send us an email at Margaret.Karen's@bmo.com. You can listen to the show and subscribe on Apple podcasts or your favorite podcast provider. And we'd appreciate it. If you could take a moment to leave us a rating and a review. This show and resources are supported by our team here at BMO, including the FICC Macro Strategy group and BMO's marketing team. This show is produced and edited by puddle creative.

Automated voice:

This podcast has been prepared with the assistance and employees of bank of Montreal, BMO, Nesbitt Burns Inc, and BMO Capital Markets Corporation together BMO who are involved in fixed income in foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts.

Automated voice:

Notwithstanding before going this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on his podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment or strategy referenced here in maybe suitable for you. It does not take into account the particular investment objectives, financial conditions, or needs of individual clients, nothing in this podcast constitutes investment legal accounting, or tax advice, or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise it constitutes an opinion or a recommendation to you. BMO was not providing advice regarding the value or advisability of trading in commodity interests, including futures, contracts, and commodity options or any other activity, which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act.

Automated voice:

BMO is not undertaking to act as a swab advisor to you, or in your best interest in you to the extent applicable will rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment. You should conduct your own independent analysis of the matters referred to here in together with your qualified independent representative if applicable. BMO assumes no responsibility for verification of the information in this podcast, no representation or warranty is made as to the accuracy or completeness of such information. And BMO accepts no liability whatsoever for any loss arising from any use of or reliance on this podcast. BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter, and information may be available to be BMO and or if affiliates that is not reflected here in your mind when its affiliates may have positions long or short and affects transactions or make markets insecurities mentioned here in.

Automated voice:

We'll provide advice or loans, do we participate in the underwriting or restructuring of the obligations of issuers and companies mentioned here in. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast for further information, please go to bmocm.com/macrohorizons/legal.

 

Margaret Kerins, CFA Head of FICC Macro Strategy
Ian Lyngen, CFA Managing Director, Head of U.S. Rates Strategy
Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy
Dan Krieter, CFA Director, Fixed Income Strategy
Benjamin Reitzes Director, Canadian Rates & Macro Strategist
Dan Belton Vice President, Fixed Income Strategy, PHD
Ben Jeffery US Rates Strategist, Fixed Income Strategy



You might also be interested in