Doomsday scenario - QT liquidity crunch

Investment Analysis Clubs Macro Economic Trends and Risks
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Ok, Ok. “Doomsday scenario” is a bit hyperbolic. But I didn’t say it – it’s a quote from this WSJ article.

METARs have been discussing the impact of the Federal Reserve’s increase of the fed funds rate. But the fed funds rate is just an overnight rate. The longer-term interest rates are much more important to the economy since they determine mortgage, corporate bond yields, etc.

Quantitative Easing (QE) by the Fed has bought $8.8 Trillion of Treasuries and mortgage-backed securities (MBS) using fiat money created out of thin air. That was monetary stimulus which suppressed long-term interest rates. (For comparison, U.S. GDP is $25 Trillion.) QE pumped up all asset values, including bonds, stocks, real estate, etc. with ultra-cheap lending.

https://fred.stlouisfed.org/series/WALCL
https://fred.stlouisfed.org/series/GDP

Starting in June 2022, the Fed began to very gradually reduce their massive, bloated book of bonds by letting them roll off – not buying new bonds as their existing bonds mature. This is called Quantitative Tightening (QT). The minuscule pace is scheduled to double in September.

https://www.wsj.com/articles/the-other-doomsday-scenario-loo…

**The Other Doomsday Scenario Looming Over Markets**
**A U.K. fund manager says the big worry isn’t inflation, it’s the Fed reversing quantitative easing**
**By James Mackintosh, The Wall Street Journal, Sept. 3, 2022**

**....**

**London-based Ruffer LLP is concerned that the accelerating runoff of the Fed’s Treasury holdings will suck liquidity out of the markets — just as rising rates and falling stock and bond prices increase the need for cash to smooth the drop....**

**The Fed doubles the pace of its bond runoff this month, aiming to reduce its Treasury holdings by $60 billion and its mortgage-backed securities by $35 billion monthly. Those concerned about the impact include hedge fund giant Bridgewater, which thinks markets will fall into a “liquidity hole” as a result. ...**

**Ruffer expects widespread withdrawals from fund managers after the terrible year they’ve had, forcing sales of stocks and bonds. If banks are constrained and unwilling to deploy money, they won’t cushion price declines and markets could drop suddenly....**

**There are enough other issues — especially the market’s failure to prepare for weaker earnings next year — to keep me bearish on stocks, but inflation makes cash an expensive place to hide. Still, QT is a risk to watch closely, because it’s only boring until it suddenly isn’t.** [end quote]

Inflation does make cash an expensive place to hide. The place to hide cash, for the moment, is in short-term Treasuries, TIPS and GSE bonds (short-terms available on the secondary market). Since QT involves the Fed rolling off MBSs, I expect the yields on GSE bonds to rise in September and beyond.

Wendy

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Inflation does make cash an expensive place to hide

But better than dropping equities perhaps? I have zero desire to hold bonds in my IRA, mostly because I think my only option would be bond funds, not actual bonds. And no way am I holding a bond fund.

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Inflation does make cash an expensive place to hide

But better than dropping equities perhaps? I have zero desire to hold bonds in my IRA, mostly because I think my only option would be bond funds, not actual bonds. And no way am I holding a bond fund.

I always ask: What do they mean by “cash”? Since nobody keeps greenbacks in a mayonnaise jar and forgets about them. Ever since I’ve been doing this (1984) “cash” means MM funds, CD’s, bank accounts and the like.

I found online a while ago what MMFs were paying vs inflation at the peak of the spiral, 1980.
It was within one (1) percentage point of the inflation rate. That’s not what I call “making money” but it sure isn’t losing money a la crashing bonds and a crashing stock market. You’re staying in the ballgame. I see cash, as defined herein, as friendly a place as there is to store actual “cash”. Forever? No. Until things are looking up? Where else ya gonna go? Dabble in real estate and gold? If you’re good at that I wouldn’t say don’t.

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Yep.

My stocks are down about 13 percent year to date, indices are down more than that, and bonds Are down 10 to 12 percent, give or take. And stocks and bonds appear to have farther to fall.

My cash is paying 1 percent and rates are rising monthly.

Sometimes minimizing losses is the best you can do.

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… hedge fund giant Bridgewater, which thinks markets will fall into a “liquidity hole” …

Sounds like Turkeys voting for Christmas … of course these guys want the market to remain pumped up …

https://www.statista.com/statistics/1121448/fed-balance-shee…

So the Fed balance sheet was 4.5 tr around 2014-2018 and everyone was happy. Now it’s 9 tr, going down by 95 bn a month, 1.14 tr a year. 4 years to get back to the comfortable level of 4.5 tr … yet the bleating has started already?

Sure, asset prices will subside, that’s the idea but the only liquidity black hole will be anyone overleveraged into volatile asset classes like crypto … oh and asset managers’ fees and bonuses …

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<I have zero desire to hold bonds in my IRA, mostly because I think my only option would be bond funds, not actual bonds. And no way am I holding a bond fund. >

Fidelity makes it easy to buy individual bonds in an IRA (Traditional or Roth). You are right about NOT buying a bond fund in a rising interest rate environment. Buy short-duration bonds, hold them to maturity. Wait until the Fed starts cutting interest rates again. Then either buy longer-duration bonds and/or bond funds.

Of course, at that point stocks will also begin to recover.

Wendy

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The place to hide cash, for the moment, is in short-term Treasuries, TIPS and GSE bonds (short-terms available on the secondary market).

I had a talk with my Schwab rep (3 decades of experience, and he’s given me some excellent advice previously) about cash. He said that standard TIPS are behaving like ordinary bonds right now—or worse—because inflation is already baked in. There is a short term TIPS ETF, VTIP, that’s been performing better.

His favorite alternatives to TIPS: Short term treasuries up to 2 years. Beyond 2 years, go with CDs.

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I suspect this entire tightening exercise is an monetary / political placebo on the part of the Fed and those that like to believe the Fed can ward off economic calamities years / decades in the making.

Imagine a machinist or first mate somewhere in the bowels of a giant ocean-going ship whose responsibilities include one bolt in an equipment room somewhere. Imagine the captain of the ship and the owner of the shipping firm have gotten it into their head that the torque on that ONE BOLT in that ONE equipment room somehow directly influences the engine room and the rudder of the ship. As the ship has sailed around the world in various types of seas, analysis of storms and the ship’s handling has led the captain to direct that this single bolt be loosened a little bit each time the ship seems headed for rough seas and by golly, every time they loosen the torque on that bolt, the ship makes it to port without incident.

After decades at sea and incremental reports from the captain and shipping company to the customers about how they have managed to survive rough seas via continued adjustments to that bolt, EVERYONE treats that bolt as THE tool for fending off all problems. Only now the captain has visited that equipment room and – like the machinist or first mate – now sees the bolt is completely unrelated to propulsion or steering. It’s just one bolt of twenty in a bulkhead and, due to a design oversight, isn’t actually connected to anything on the other side. And now it’s at nearly zero foot-pounds of torque.

Since everyone seems convinced the torque on that bolt has outsized “ramifestations” on other issues that are largely psychological to begin with, rather than coming clean and telling the owner the bolt is hooked up to nothing and the torque doesn’t matter, the captain decides to tighten the bolt back up – sending a “signal” to the market – so that a few months later when the ship nears rough seas again, the captain can duly report the torque has been reduced, calming the shipping company and its clients.

The economy is the boat. The captain is the Federal Reserve Chairman. The shipping company is Congress and the President. The cargo on the ship is the junk we’re all demanding from a worldwide economy facing shocks due to technology, pandemics, war and social issues – none of which whose most IMMEDIATE causes are influenced by interest rates, the “bolt” in this convoluted analogy.

If Putin manages to damage Europe’s largest nuclear reactor complex in the same year that Lake Powell and Lake Mead reach dead pool status eliminating 39 billion kilowatt hours of domestic electricity production in the US, the Fed could raise or lower interest rates twenty percent and it wouldn’t avoid one ounce of economic pain. We would see $200/barrel oil prices and an instant worldwide depression. With these black swans circling, fixating on interest rates seems like so much monetary theatre.

WTH

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The economy is the boat. The captain is the Federal Reserve Chairman. The shipping company is Congress and the President. The cargo on the ship is the junk we’re all demanding from a worldwide economy facing shocks due to technology, pandemics, war and social issues – none of which whose most IMMEDIATE causes are influenced by interest rates, the “bolt” in this convoluted analogy.

It’s a funny story, but a complet canard.

I don’t know anyone who thinks the Fed has the power to overcome a nuclear holocaust embracing Europe while a once-in-500 year drought captures the US West Coast, and what the heck, let’s throw in a continuing pandemic lockdown in Asia.

The “Fed” is a tool. Not every tool will solve every problem. I’ve tried smashing nails into concrete walls using Ginzu knives, but it hasn’t worked very well. On the other hand, a frequent problem of modern (an prior, actually) economies is the tendency to overheat and overproduce, then fall into recession as that excess inventory is worked off. Unfortunately during the “work off” period people lose jobs, the populace hunkers down, and suddenly everyone finds themselves in undershoot territory. Lather, rinse, repeat. The business cycle is manic, and the Fed is a mood stabilizer. Prior to the creation of the Fed depressions and panics happened about every 20 years, Depressions worthy of the name, and there was often a recession or two in between. You can look to the history of the 18th and 19th centuries which are pretty well documented, but we have some knowledge of the times before that as well.

In the century since the creation of the Fed we have had two Depressions: 1930 and 2008. 1930 lasted a decade because of the belief of “do little”, and 2008 was shorter and less severe because the Fed (and other government programs) followed the mantra of “do as much as you reasonably can, and do it fast.” It seems likely that 2020 would have been another thanks to the pandemic, except the Fed and other firehoses were turned on full blast, and the economy briefly hiccuped and then returned as robust as before. Two in a century, a pretty good record.

To reiterate, the Fed isn’t “the bolt”, it’s one wrench on a very large ship, but it’s a bigass wrench, and used in combination with other wrenches, hammers, and tools, has been demonstrated to work pretty effectively over a variety of situations. That doesn’t mean it’s perfect and that black swans won’t appear that could overwhelm it, but this silly criticism of a mantra never made - that it can solve everything - is just, well, beyond redemption.

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