One of the biggest “risks” for 2018 that financial media cites is QE Unwind. According to the Federal Reserve’s original guidance, the Fed would
- Initially reduce its balance sheet by $6 billion per month of Treasurys (mostly long term bonds) and $4 billion per month of MBS. The Fed will not sell its bond portfolio. Instead, it’ll simply let the existing bonds mature without reinvesting the proceeds. This is essentially the same thing as selling bonds (less demand for bonds has the same effect as more supply of bonds).
- Each quarter, the Fed would accelerate the pace of QE unwind until it reaches $30 billion per month of Treasurys and $20 billion per month of MBS. Total $600 billion per year.
What the mainstream investment world thinks about QE Unwind
Bears frequently state
This bull market has been directly caused by quantitative easing. The bull market in stocks would have been dead long ago without quantitative easing.
QE Unwind will 1) cause a bear market in stocks, and 2) cause long term yields to soar.
I disagree. Our Medium-Long Term Model is based on the tenet that the bull market is driven by the U.S. economy, which continues to improve. The U.S. economy would have recovered post-2008 with or without the Fed. The recovery would have been slower without QE, but the economy would have recovered nevertheless.
So unless QE Unwind significantly hurts the U.S. economy, our Medium-Long Term Model will not foresee a bear market in the immediate future. U.S. economic data is very robust right now.
What QE Unwind is in reality
Let’s put aside my model and discretionary outlook for now. Let’s assume that the bears are right: QE Unwind will kill the stock market and cause yields to spike.
Well it turns out the Federal Reserve has been lying. The Fed has been reducing its balance sheet at a MUCH SLOWER PACE than their initial guidance.
The Fed has reduced its Treasury holdings by approximately $11 billion from October December. As per the Fed’s original guidance, the Fed should have reduced its Treasury holdings by more than $18 billion during this period (the 3 months from October, November, December). The Fed has barely reduced its holdings in December.
Notice how the 10 year yield has been slowly creeping up in October/November and tried to breakout in December.
In other words, QE Unwind is happening at 2/3 the pace that was originally set out.
As you can see, the Fed is VERY DOVISH. It is afraid that QE Unwind will cause increased market volatility. To dampen this potential concern, the Fed is unwinding its portfolio at a much slower pace. Since the majority of QE Unwind’s Treasurys are long term Treasurys, the Fed is very dovish on the long end of the curve. This is why the yield curve has continued to flatten. Long term yields have not risen as much as initially expected (thanks to the reduced QE Unwind).
Here’s the 10 year – 2 year yield differential.
Any volatility that QE Unwind may have caused the stock and bond markets has been cut by 1/3. This means that QE Unwind is even less of a concern to stock market investors/traders than it was before.
Remember that Yellen’s term ends on February 3, 2018. Jerome Powell – the new Fed chairman – is a dove. Moreover, no Fed chairman wants the stock market to crater during the first year of his first term. This is called “job risk”. (And we all know how much Donald Trump loves the stock market. Just read his Tweets.)
The Fed is aware that a yield curve inversion signals an impending recession.
- The Fed can control the long term Treasury yield via the pace of its QE Unwind program.
- The Fed can also control the short term Treasury yield via the pace of its rate hikes.
Hence, I do not expect the yield curve to invert in 2018. This is not a free market.
- The Fed will not let long term rates soar (and crush the stock market) in 2018.
- The Fed will not let short term rates rise fast enough so that the yield curve becomes inverted.
*The best fund managers (Jeff Gundlach, David Tepper) thought that the yield curve would steepen in late-2017 due to QE Unwind. They were wrong because they did not expect the Fed to cut the size of QE Unwind.