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Michael Michaud is the founder of Invest2Success.com (http://www.invest2success.com/) and the Invest2Success Blog (http://invest2success.blogspot.com/). He has been investing and trading in the financial markets since 1989. He founded Invest2Success.com to empower individual institutional... More
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  • Where Does The Fed's Stimulus Money Go? Part IV 0 comments
    Oct 30, 2013 10:40 AM

    Where Does the Fed's Stimulus Money Go?

    Part IV - The Exit Plan

    By Dr. Van Tharp Trading Education Institute

    During the past few weeks, we've dug into some interesting topics surrounding the Fed's stimulus. While many questions remain unanswered, one will have the most impact on traders and investors: How will central banks exit the "extraordinary measures" phase and head back toward normalcy? (The other market impact question is "when?" - but the answer to that question is likely to have more short-term effects.)

    In May this year, the Geneva Conference on the World Economy focused on the topic of how central banks will unwind. A few presentations from that conference may provide us with some answers about the upcoming process. Once again, we'll dig into the rich deposits of information that came from IMF consultants Singh and Stella in their white papers that we have referenced before. While the concepts apply broadly to central bank stimulus programs, we'll simplify the explanation by talking about the exit plan for just the U.S. Federal Reserve.

    A legitimate question that one might ask is why would the purchases made through the stimulus program have to be unwound at all? While a comprehensive answer is a little more complicated, the simple way to look at this is as follows: The Fed has lowered interest rates through securities purchases that manipulate the yield curve (and of course by changing interbank borrowing rates). As interest rates approached their lower bound of zero, stimulus efforts took the form of a massive expansion of liquidity. If things were just left "as is" - with the $2.2 TRILLION of added reserves sloshing around on the books, that added liquidity would pose of threat of sending inflation rates to unacceptably high levels, given a period of sustained economic recovery and even a bit prosperity.

    To avoid this eventuality (or, in some peoples' minds, to keep it from happening), the Fed will have to unwind a large portion of this massive liquidity. The Fed will do this by raising interest rates but not by directly reducing its balance sheet and the balance sheets of the commercial banks who have been the willing parties to the multiple QE phases. So then how to unwind trillions of dollars of stimulus? That subject has been debated and now a likely path seems pretty clear.

    The Repo Man's Mirror Image

    Peter Stella outlines three ways that the Fed can raise rates: by declaration (or fiat, as he calls it), by raising rates on borrowed bank reserves, or by raising the rates of reverse repurchases.

    The first option - raising rates by fiat - has little else going for it beyond simplicity of execution. Divorced from market forces, such changes could lead to significant unintended consequences and may not adequately move longer term rates, which are most important in the real world.

    Raising the rates paid on term deposits would have the desired effect of incentivizing banks to reduce their reserve levels, but does little to help banks build back their stocks of tradable securities.

    The last option, which most signs point toward as the logical conclusion, is the use of reverse repurchase transactions.

    In last week's article, we talked about the role that repurchase agreements play in providing liquidity to institutions. In essence, as Stella describes it, the Fed would sell Treasury bonds to financial players and agree to buy them back at a set time in the future for a set fee. This fee agreement would allow the Fed to effectively pay interest like it would with term deposits while offering the double benefits of putting more high-quality collateral (namely treasuries) back into play and also being able to include nonbanks in the loop.

    Again, Stella emphasizes that the Fed has already spent time and effort to put the infrastructure in place to facilitate these reverse repos including expanding the list of approved (nonbank) counterparties who could buy and then re-sell the reverse repos.

    So What?

    That's a fairly quick but head-spinning dive into the minutiae of stimulus unwinding. Still, we can glean a couple of key points from this. First, central banks do have a chance of creating a soft landing coming out of this unprecedentedly massive monetary policy experiment. The mechanisms exist for prudent exit strategies. But - and this is a big but - the global economy is going to have to cooperate. A mild recovery will not produce the financial cover to unwind this gently and any hiccups in the system could lead to 2008-stlyle market plunges.

    The size and scope of central bank interventions over the last five years have created a financial compression that may only be relieved by an explosion rather than a process of letting the air out bit-by-bit. And many questions remain unanswered - for example, as interest rates necessarily rise and bond prices drop, who will absorb the losses in those securities as they pass through the repo cycles? More public sector burdens? Will private parties have exposure to some of this risk? We'll dig into these tough questions next week.

    Click Here to Read Parts 1, 2 and 3 of Where Does the Fed's Stimulus Money Go?

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