While Neel Kashkari may be theatrically appealing to the intellect of “QE conspiracists” – which as of today in addition to Robert Kaplan, Larry Kudlow and James Gorman also includes as per the chart below Bank of America, in addition to any other person with an even modest understanding of monetary policy…
… to explain to him how the Fed is moving prices with its $60BN in monthly purchases of T-Bills (something we did last week), an key development is coming that will make all such debates moot: in a few months the Fed’s “Not QE” will officially become “QE 4.”
The reason: following an update to BMO’s bill supply forecasts, the bank’s rates strategist Jon Hill sees a great likelihood that the Fed will need to reduce its “demand burden” on the bill market, i.e., there won’t be enough Bills available for the Fed to monetize without it distorting the market, and will extend the purchase program to include short coupons in the process officially ending any debate whether the Fed’s manipulation of the market under the guise of saving repo, is “Not QE”, because it is limited to Bills and thus no duration is taken out of the market, or is “QE 4”, in which the Fed purchases at least some coupon securities in addition to Bills.
Once the Fed makes the shift, BMO expects the monthly sizes of $60 bn, or $30 bn post assumed taper, would be composed of both bills and short coupons, “helping to reduce expected pressure in the bill market. ”
At this point, Hill puts 75% odds on this change occurring by mid-March, meaning that any farcical “debate” whether the Fed’s injection of anywhere between $60 and $100BN in liquidity each month into the equity market, is or isn’t QE, will very soon be mercifully over.
What if BMO is wrong, and the Fed does not adjust purchases to include short coups? In that case, the Canadian banks foresees a $321 billion reduction in bill supply in Q2 2020…
… which would be the largest quarterly drop in privately available outstandings on record.
Furthermore, Hill predicts that that the Treasury’s introduction of 20-year supply would also marginally contribute to reduced Q2 bill issuance.
This squeeze is driven more by the Fed’s purchase program, rather than a sudden shift in the Treasury Department’s cash needs. Indeed, a look at borrowing needs less net coupon issuance shows Q2 2020 will be -$236 bn, essentially in line with -$229 bn in Q2 2019. In other words, what makes Q2 2020 different is the full consequences of the Fed’s footprint in the bill market.
It is also worth noting that that these figures reflect BMO’s assumption that the Fed tapers their “reserve management program” (and soon, QE-4) from $60 billion per month to $30 billion per month in mid-March, so if the tapering does not occur, the squeeze will be that much more.
Now, “why doesn’t the Fed stop their Bill (and soon Note) Purchases earlier?” one may ask? The short answer, according to Hill, is that the system still requires reserve injections – after all anything less and the equity market will crack – and the Fed wants to gradually reduce its repo footprint. While repo take-up from the Fed has fallen by $80 bn since year-end, there remains nearly $200 bn in demand. Since the beginning of December, the combined reserve management purchases plus repo injections has been approximately $400 bn.
As a result, in BMO’s baseline scenario, the bill purchase program will total $390BN by the time it is unwound (before it returns again, of course). This will continue to displace demand for Fed repo operations, but not at a sufficient pace as to allow for a full stop of the reserve management purchases before Q2. Instead, and as we predicted last October, the most prudent policy adjustment per Hill, appears to be expanding the program to include short coupons in the next couple months