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Why China's recent actions will lead to higher QE bond purchases
Published: 04-12-2013 00:00
By: Vincent Tie
The word ‘taper’ has never gotten so much attention than in 2013 when it was used to describe the gradual tightening of the money printing spigot of the Quantitative Easing (QE) program. It started in March when the Federal Reserve said that they will reduce the QE bond purchases if economic indicators improve.
In April, a number of top Federal Reserve officials fed the media with more taper talk. St Louis Fed Bank president James Bullard said that he favoured “trimming” the QE program in $10-$15 billion increments if the economy improves. Then John Williams, president of the Federal Reserve Bank of San Francisco, said that if there was substantial improvement in the labour market, the Federal Reserve “could end the purchase program sometime late this year”. In May, it was the Federal Reserve Chairman Ben Bernanke’s turn to spread taper chatter by admitting that tapering QE could happen in the coming FOMC meetings if economic data warranted it. In June, Bernanke announced to reporters in a post-FOMC meeting press conference that the central bank expected QE tapering later in the year and end it some point in mid-2014. He gave the analogy of driving and that the Fed was merely lifting its foot off the gas and not slamming on the brakes.
Despite Bernanke’s attempt to convey that tapering will be gradual, the markets sold off sharply. The stock markets fell and the yields of the US Treasury surged. Just about everyone believed that the Fed will taper QE in September. When September came, the Fed surprised everyone by saying that the economy was still weak and they would not taper QE. Since then, the markets have been trying to guess again when QE taper will happen.
Why tapering QE is a sideshow
The best way to understand why second guessing whether the Fed will taper QE by $10 billion or $15 billion is rather meaningless is summarized by what David Stockman said:
“This is the fifth year since June 2009. Still buying $85 billion a month is lunatic. To pull back to $70 billion? This is changing the deck chairs on the Titanic.”
If you were on the Titanic, it did not matter where you sat on the deck because eventually the ship sank. Given the already abysmal fiscal position of the United States and she having a debt that cannot be paid off mathematically, it is a matter of ‘when’ and not ‘if’ a debt collapse will happen in the future.
Having a balance sheet like that of a bankrupted spendthrift will hardly give confidence to private investors to lend the US government money. This was why the Federal Reserve had to step in and buy bonds through QE. By doing this, it created an artificial demand for government bonds and kept interest rates low for the US government to borrow cheaply from the market. The Federal Reserve has come to buy up to 70% of all net US government bond issuance. Investors do not mind buying the bonds at low yields since the Fed’s presence conveyed that the risk of a lack of demand for the bonds was low. As long as the Fed is in the market to buy bonds, the chances of someone buying bonds when the investors need to sell is high.
Tapering QE means that the Fed will buy less of the government bonds from the market. This slack in buying will have to be picked up by some other party because otherwise who will lend the government the money it needs to spend? If the Fed were to taper QE, it gives investors less incentive to lend money to a government with poor fiscal position at such low yields. Remember that the US government came close to default in October 2013. It cannot be further reiterated just how bad of an investment it is to lend money to a party with poor credit-worthiness and high potential default at low interest rates. The lender is just undertaking too much risks.
Foreign demand for US government bonds is waning
Last month, the financial markets poured over the Federal Reserve’s meeting minutes in their bid to assess if a QE taper is on the horizon. While the US central bank was largely silent on the topic, most observers missed what the Chinese central bank publicly announced. Yi Gang the deputy governor of China’s central bank announced that further accumulation of foreign currency reserves was no longer in China’s interest.
Given that China has a $3.66 trillion balance sheet of which almost half ($1.3 trillion) are US treasuries, it is likely that the announcement will lead to a reduction in China’s purchase of US government bonds. While they may not dump the bonds, which will trigger a sell-off in the bond market, China is able to hold the largely short-term bonds to maturity.
Without further demand from the Chinese for US government bonds, someone else will need to step in to buy the bonds to prevent the likelihood of a US government bond auction failure which will cause bond yields to spike. This is frowned upon as it makes the governments’ borrowing much more expensive.
Without the buying of US government bonds from a large net creditor nation like China, other investors will be less keen to buy the bonds given the low bond yields. This will be a conundrum for the Federal Reserve since the purpose of the QE program was to keep interest rates artificially low to allow the US government to continue to borrow cheaply.
The governor of the Chinese central bank, Zhou Xiaochuan, had also indicated last month that the central bank will 'exit' currency interventions in the renminbi. This means that the value of the renminbi will rise since China is going to reduce the buying of US dollars for the purpose of suppressing the value of the renminbi. The dollar will depreciate in terms of the renminbi – another reason for investors to avoid US government debt at low yields. They are more likely to buy Chinese government debt given the higher yields and better fiscal position of China.
It is therefore hard to see how the Federal Reserve can taper QE without resulting in a fall of demand for US government bonds under such circumstances. If anything, it is more plausible that they increase the $85 billion a month QE amount given China’s public disenchantment to US government debt. The QE taper talk is an unnecessary distraction – the Fed cannot taper QE. They are talking about it only because it wants to give lawmakers and the public assurance that it will not monetize the government’s debt forever – that it has an exit strategy. Unfortunately, money printing has always been a slippery slope. The Federal Reserve has to continue QE and eventually increase it if the US government debt is not reined in. Expect more inflation ahead.
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