E The Fed’s Shift From Quantitative Easing To Quantitative Tightening Has Increased Long-Term Interest Rates -

E The Fed’s Shift From Quantitative Easing To Quantitative Tightening Has Increased Long-Term Interest Rates

Oct 26, 2018Jeremy ParkinsonFinance, No picture0

The following chart was extracted from the October 10th Daily Shot report from the Wall Street Journal.

As the chart illustrates, the Federal Reserve shifted into its quantitative tightening (QT) mode last year. At the same time, the ECB began to reduce its purchases of securities in March of 2017, and the complete ending of the ECB QE program is scheduled for the end of this year.

The projected decline in US Treasury holdings shown in the chart is based on recent Fed staff estimates. As the chart indicates, the reduction of the Fed’s holding in US Treasuries has had the expected impact of increasing the 10-year Treasury yield. The yield on the US 10-year Treasury recently rose above 3.2%, which is the highest it’s been since July 2011.

The consensus view in the market is that once the rate has topped 3% — the monetary squeeze really became significant. Indeed, Fed Chair Jerome Powell indicated in a recent speech that interest rates are a “long way from neutral,” In other words, one more rate hike is likely at the end of this year, and several more rate increases are coming in 2019.

The latest escalation of the 10-year Treasury yields has clearly spooked the equity markets. Why the worry? Here are some of the obvious the risk factors.

The increase in interest rates paid on 10-year Treasury bonds seems to reflect a worsening inflation outlook, an observation which seems to be supported by Fed staff projections. Nonetheless, the yields on inflation-protected bonds have moved up mostly in lockstep with traditional bonds in recent weeks, suggesting that the markets are still fairly relaxed on inflation not escalating too rapidly.

Secondly, in its August policy statement, Fed officials upgraded their assessment of real economic growth to “strong” from “solid.”

Then there are the huge debt concerns for the private sector and the US government. It is well known that the fully employed American economy must finance a $21.3 trillion national debt and a near-$800 billion annual deficit. (The huge increase in the Trump/Republican budget was fueled by large tax cuts and increased government spending.)

This also means that a growing share of the federal budget will have to be allocated to interest expenses. Of course, in the current environment, interest rates are expected to rise further, thus putting a squeeze on what the federal budget can possibly accomplish.