Tomorrow is the one year anniversary of the Fed’s announcement of “open-ended” QE, or as we dubbed it, QEternity. A few months later, as Operation Twist expired, the Fed also announced the current distribution of securities subject to monthly monetization: $45 billion in Treasurys, and $40 billion in Mortgages. Sadly, QEternity has failed at stimulating the US economy: in fact, in the last two quarters, nominal GDP growth was 3.1% and 3.1%, which is about 30% lower than in the two quarters preceding last year’s announcement, when it was 4.8% and 4.5%. However, the bigger issue, i.e., “permissive” factor that allowed the Fed to unleash QE, had nothing to do with the economy, and everything to do with monetizing gross US bond issuance in both the Treasury (deficit funding) and Mortgage (stimulating housing) markets. And while we will follow up on how the dynamics of the MBS market have changed in the past year later, one thing is absolutely certain: the amount of bonds available to the Fed for purchasing has declined substantially.
Moments ago the Treasury reported its deficit for the month of August, which was $148 billion, slightly less than the $150 billion expected. More importantly, it was over 22% less than the deficit from August 2012 when it was $191 billion. And that, in a nutshell, is the main reason why the Fed has no choice but to taper.
What the chart below shows is the cumulative deficit of the US for fiscal 2012 and 2013. What becomes immediately obvious is that with the total deficit Year to Date of $755.3 billion running 35% below the $1,165 billion from a year ago, the Fed has far less room to monetize gross issuance.
In other words, all else equal, matching the reduction in the deficit (and thus the required issuance needed to fund it, and from there, monetization by the Fed), Bernanke will have to cut the average monthly purchases by 35%, or from $45 billion to $30 billion, all esle equal, suggesting a $15 billion taper.
Of course, all else is not equal, and the other issue is that gross mortgage-backed security issuance has also tumbled: after all who needs mortgages in a market that is 60% all cash buyers. A quick back of the envelope analysis indicates that the matched reduction to keep up with the creation “flow” from a year ago, the Fed would need to taper its MBS monetization by over $10 billion, leading to a combined tapering amount of $25 billion.
Of course, the Fed can delay the full implementation of this reduction, and as many have suggested, start with a far more modest tapering of just $10-15 billion. While this may help pushing stocks higher (if do nothing for the economy), it also means that the Treasury and MBS market will become increasingly more illiquid. Recall that as we showed recently, the Fed already is in possession of 32% of all 10 Year equivalents in the Treasury market, or in other words, the Fed controls one third of the US bond market.
The trade off: a very angry TBAC, which in both of the past two refunding announcements (here and here), has complained loud and clear about the disappearance of high quality collateral, i.e., Treasurys (and to a lesser extent MBS) from the private market.
And that is the Fed’s dilemma: delay tapering to $25 billion or more and suffer an even more illquid bond market in hopes that finally, after five years of failed attempts, growth, inflation and/or employment will finally pick up, or finally admit that it has failed at anything but ramping stocks ever higher, and not risk breaking the bond market any more.
We will know in precisely six days what Ben’s choice will be.