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Should anyone really expect that the new program will end in the middle of next year as the Fed now suggests? It has never fully ended any of its prior stimulus plans, why would this one be any different? In fact, thanks to the Fed, the U.S. economy will be even more heavily indebted in eight months than it is now. So the Fed will be forced to buy even more debt to keep interest rates from rising in an economy even more vulnerable to higher rates than it is today. Like any drug habit, the more drugs you consume today, the more you will have to consume tomorrow to achieve the desired effect.
If we can agree that it makes no difference what we call the program, it is nevertheless important to focus on the differences between QE then and QE now. Back in 2009, the program was all about reliquifying the long bond market that had been decimated by billions of dollars of worthless subprime bonds. But a decade later, the home mortgage market is relatively calm, at least for now. Long-term interest rates are already rock bottom, and mortgage delinquencies are not currently causing panic in the banking system. Today, problems are popping up in a very different place, the very short-end of the bond market, particularly in the overnight “repos” where banks lend spare cash to one another on a very short-term basis.
As it turns out, the Fed’s $50 billion per month of bond sales, which began early in 2018 and ended in the second quarter of this year, drained liquidity from the overnight market at the same time increased government borrowing was sucking up all available cash. Last year’s tax cuts, combined with increased Federal spending, pushed this year’s deficit past $1 trillion for the first time since 2012. (G. Heeb, Markets Insider, 9/14/19) Deficits are currently expected to stay north of $1 trillion per year for the foreseeable future. That means more new government bonds than expected are likely to hit the market.
Contrary to his campaign promise, President Trump has actually shortened the maturity of the national debt. (US Govt. Finance: Debt, Yardeni Research, Inc., 10/10/19) Shorter maturities mean that more debt will need to be refinanced each month. Banks have dutifully bought those bonds, as they are often required to do by capitalization laws that were put in place since the Crisis of 2008. But this has not left enough cash to keep the overnight market well-lubricated.
This problem erupted into broad daylight just a few weeks ago, when yields on overnight bonds skyrocketed to 10% or more. Rates that high in an overlooked, but vital, part of the financial system could have caused the economy to seize up, so the Fed intervened with all guns blazing. It bought approximately $53 billion of overnight loans in just the first day of the crisis.
At that point, most market observers believed that the problem was caused by a confluence of temporary events that would last just one day, or maybe a week. But those hopes quickly faded, and we have been left with a crisis that now appears permanent. In light of this, it is not surprising that the Fed expanded its intervention into the short-end of the Treasury market. But don’t expect the problems to end there. The debt crisis is like a cancer that I believe will continue to spread. The Fed is out of miracle cures. In fact, it never had any.