Investing Advice: A Big Week for Central Banks

Posted On June 13, 2018 2:03 pm

This is a big week for Central Banks decision making regarding monetary policy.  If the Euro’s Draghi and Japan’s Abe follow the U.S.  Federal Reserve’s William’s shift towards higher rates will this upset the ongoing bull market? Today’s investing advice explores the possible implications for traders.

The U.S. already halted its Quantitative Easing (QE) policy and this afternoon the Federal Reserve is expected to announce a continuation of the path three more interest rate hikes this year.

But Europe and Japan, whose ECB and BOJ are also scheduled to meet this week, have yet to halt their asset buying programs which has kept U.S. rates anchored artificially low.  The question is, what will happen if, as some believe, they start winding down their balance sheets.

Callum Thomas gives us a run down and shift policy towards one of Quantitative Tightening (QT)

Here’s what he has to say:

As the Fed is steadily progressing through its balance sheet normalization plan, it’s worth checking in on a few charts that highlight the path to normalcy.

And some of the potential stumbling blocks along the way The beginning of large scale asset purchases (or QE – Quantitative Easing) in the wake of the financial crisis was a grand monetary policy experiment, and we are now entering into another grand monetary policy experiment.

The key takeaways on quantitative tightening (or QT) are:

  • QT is set to rise from a current potential $30B per month to $50B in Q4 this year.
  • All else equal QT is likely to be a headwind for both stocks and bonds.
  • Globally the ECB and BOJ are providing some offset, but will each be heading for the exits at some point too.
  1.  Fed Balance Sheet Normalization Plan

As outlined in the Fed’s plan for balance sheet normalization, the Fed has embarked on a progressive quantitative tightening program whereby it will allow its balance sheet to be run down over time.  The chart below shows approximately how this will play out.  Currently the total monthly pace of Quantitative Tightening is a potential $18B in treasuries and $12B for asset backed securities (combined $30B), all going to plan, this will rise to $30B in treasuries and $20B in ABS (combined $50B) in Q4 this year.  For context, at its height QE3 was running at a pace of $85B per month.

  1.  Cumulative Amount of Quantitative Tightening (QT) Undertaken

Since commencing Quantitative Tightening total assets have been reduced by over $120B and of that holdings of treasuries have been reduced by $80B in total.  Thinking about this chart and the previous chart, and traditional policy tool of the Fed funds rate, I can’t help but wonder if there may be a “neutral level of the balance sheet”, just like there is the concept of a neutral Fed funds rate…

  1.  Quantitative Tightening vs Bond Yields

The commencement of QT coincided with the start of a reasonably sizable move in US 10-year bond yields.  There are of course many factors that come in to play for bond yields (namely inflation, economic growth, etc), but from a flows standpoint less reinvestment means less purchases, and balance sheet rundown means less holdings locked out of the market on the Fed’s balance sheet.  So all else equal, Quantitative Tightening should drive yields up at the margin.

 Related: Learn Everything You Need to Know About Financial Psychology Here.

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Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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