QE: A monetary Mobius strip?
In late August, we caught up with Insight fixed income fund manager Gautam Khanna to hear his view on the long-term implications of quantitative easing. In this extended Q&A, he discusses central bank intervention, the prospect of inflation and how the stimulus will be financed.
Q: How does QE initiated in March compare to prior times the Fed used this tactic during and after the subprime mortgage crisis? What’s different this time around?
- Speed – much faster
- Size – much bigger and faster
- Breadth – more broad based with purchase of ETF’s, individual corporate bonds…Activity mostly secondary but also primary facility available
- In past QE programs, the Fed generally bought no more than US$80 billion per month. In March and April, the Fed peaked at over US$300 billion in treasury purchases PER WEEK. The size of this activity was absolutely without precedent
- One difference is that the Fed still calls this a “market liquidity” program rather than a “QE” program and has not tied it to any economic indicators. They have committed to purchase at least 50 billion of mortgages and 80 billion of treasuries per month “over the coming months” ie at least through year end.
Q: The Fed added about US US$2 trillion to its balance sheet from March to July through its bond buying programs. Since there’s usually a lag between when stimulus is implemented and when inflation kicks in, what is the Fed going to have to do to catch up with inflation if it overshoots its target?
- This is a great question without a clear cut road map. Weaning the market and economy from QE is not going to be easy. It is likely that the Fed will be slow to remove accommodation and stimulus and therefore allow inflation to overshoot.
- While inflation is a longer term concern given massive injection of liquidity…this is not front of mind as unemployment will remain elevated for a while and there is enough slack in the system that inflation is not a worry
- It is also important to note that the Fed likely wants a modest overshoot of its inflation target to make up for years of sub 2% inflation. This policy preference gives it more room to let its balance sheet naturally moderate than having to act to clamp down inflation
- With other major central banks also doing huge QE, the impact on the currency, and thereby inflation, is lower than if the Fed acted alone, giving it more room on its balance sheet
Q: If inflation picks up beyond the Fed’s ability to slow it with rate hikes, how might investors respond?
- Perhaps their allocation emphasis would shift more to those areas that are defensive against rising rates like floating rate instruments as well as spread / credit assets where underlying default probabilities are likely to recede as it becomes easier to grow into existing debt loads and de-lever through growth in EBITDA and earnings which then in turn leads to spread compression
- There are many areas within the securitised asset class that are either shorter maturity and therefore defensive against rising rates or floating rate in nature which would be natural areas for the portfolios to look.
- TIPs would likely outperform nominal treasuries in such a scenario.
Q: In an ideal world, QE prompts banks to increase lending and coprorations to issue more debt—but is the post-covid economic environment so unique that this hasn’t been the case?
- Corporates have issued more debt…indeed, 2020 issuance YTD exceeds the total issuance in most calendar years at nearly US$1.5 trillion. A lot of debt has been termed out and maturities have been pushed out. The duration of the investment grade corporate index has lengthened to almost 9 years as a result. The default probabilities of issuers in this category has improved from the depths of the crisis.
- On the lending side, banks have extended over US$900 billion of credit, in large part due to deposit growth. Banks have also increased lending to corporations by US$250 billion and increased MBS holdings by US$150 billion. Given the stimulus, consumers have paid down credit card debt
Q: QE has been a global response to the Covid fallout. Considering the ECB has been using it as well—because of the scale of the Fed’s asset purchases in comparison to other central banks, can we expect to see the dollar weaken further? What effect would this have on different bond sectors and how might US bond managers decide to allocate differently if this is the case?
- Currencies move based on relative differentials of interest rates, economic stability, growth rates etc. Beyond these fundamental factors is perceived strength and stability of certain regions that drives flows into and out of currencies. While the dollar has been weaker, and that weakness could persist for the near term we don’t believe that the USD weakness can persist for the intermediate or longer term.
- Indeed, some of the dollar weakness is a sign of policy SUCCESS as the dollar weakens during periods when markets feel more optimistic about growth. While the Fed is being 2x as aggressive as the ECB, the recent stimulus effort by the EU has likely driven the euro higher as signs of greater fiscal coordination reduce risk of a break-up of the EU
- Historically foreign flows into USD assets, from Asia in particular, increase after dollar weakness which would support corporate spreads
Q: Since QE prompts the flight to riskier assets by pushing yields down on assets the Fed purchases—how might the opportunity set change over time? Are there areas of your investible universe that may become more attractive? More risky?
- Sub investment grade could benefit and pure duration could become more risky. The long bond at 1.42% with a duration of 24 could well prove to be a risky asset.
- Lower starting yield increases the probability of negative total returns, holding all else constant
Q: Is there a possibility that a corporate debt bubble will form over the long term? Does this further bolster the team’s conviction in its prioritization of balance sheet strength?
- A corporate entity tries to optimize its weighted average cost of capital (WACC). To the extent cost of debt is going down relative to the cost of equity it is rational for corporate CFOs to add more debt to the balance sheet. But increasing the debt component of the capital structure also increases the fixed costs of an enterprise and eventually reaches a tipping point where the incremental debt increases the potential for default and the cost of financing starts to go up rapidly. As bond investors we need to assess the credit worthiness and sustainability of the capital structure and the stability of underlying ratings and default probabilities when picking our investments. This is always important but more so today when leverage ratios are on the rise and the underlying economy is still in the recovery phase.
- It is also important to note that many companies that came to market like Disney, Visa, Coca-Cola have 200+ billion equity values. So yes, they are more levered, but these are very valuable, resilient, and large entities
Q: Could there be increased risks of corporations going bust in the long term and what happens if we see a drastic increase in defaults? How would your analysis change and again, how would you insulate your portfolio from these risks?
- Default rates are projected to rise in areas directly impacted by covid 19 and in areas where negative secular trends already in place accelerated due to covid 19.
- Diversification in the portfolio and emphasizing balance sheet strength and staying power is very important.
- Our investment philosophy and process are well positioned in delivering a stable outcome in these challenging conditions.
Q: How does the importance of security selection and not just blindly investing in any one part of the market serve as downside mitigation in the event this round of QE does lead to an undesirable outcome?
- Security selection is particularly important as is industry selection. In this evolving economic environment, there are clear winners and losers by Industry and by individual issuer. For instance, online wins over brick and mortar retail; Supermarkets and food companies win over restaurants; metals and mining likely does better than energy, industrial REITs do better than mall REITs, etc.
- Active management can capitalize on these differences at the industry and at the issuer level.
Q: What will happen when the Fed finally decides to unwind its balance sheet? Will it be more difficult to do, without upsetting markets, than it was prior to the pandemic? Is there anything investors should be cognizant of when his happens?
- Unwinding the balance sheet will be a deliberate process that will likely take a long time and will be more difficult to achieve. Who would they sell their ETF holdings to as they don’t have an end date for instance? The fed’s buying and selling can have a significant impact on market technical and supply / demand balance and needs to be considered carefully.
- Historically, the fed prefers to slowly let its portfolio mature and not fully reinvest proceeds. That will be the path here and will likely being post 2022
- Also remember that holding the B/S flat shrinks it over time as a % of GDP
Q: In regard to treasury financing, how will the Fed pay for all the stimulus and what effect will the growing budget deficit have on the long end of the yield curve?
- Fed treasury purchases from newly created dollars are financing most of the deficit. As we saw during the financial crisis, balance sheets grow much more quickly than they fall, and so much of the increased debt load and larger balance sheet should be viewed as quasi-permanent
- We would also note that the increased public sector deficit is largely being offset by increased private sector savings with US households poised to save over US$3 trillion this year. These increased savings can help finance the deficit.
- If the long end steepens, the Fed can do another operation twist or purchase more long bonds to keep a lid on rates to minimize the government’s borrowing costs
- The Fed and private sector demand for assets will keep a lid on rates, which is why sell-offs have proven to be buying opportunities
Q: What are your expectations for auction sizes and issuance for US Treasuries and what effect will that have on the shape of the curve and the composition of major market US indices like the US Agg? Will this make a stronger case for the Agg as the “inefficient frontier”?
This is monthly treasury issuance. We would expect a similar pace next year as the Treasury faces a US$2+ trillion deficit and terms out its increased bill issuance. This increased issuance could increase treasury’s weighting in the agg by 3-5% depending on issuance from other sectors