Spoiler alert: QE does not work as advertised.
The title of this Collection probably gave that away, but it bears repeating nonetheless. Why? Because of how much misunderstanding that surrounds this topic. Markets move wildly every time the words “Quantitative Easing” show up in the headlines, investors make forecasts decades out into the future based on the amounts of money QE pumps into the system; and traders see the ghost of more QE behind every poor data point and between the lines of every central banker’s statements.
Believe it or not, all of this has been going on for five years in the Eurozone, ten years in the States, and almost twenty years in Japan. Doesn’t an “extraordinary” monetary policy measure having such longevity hint at its inefficacy? After all, “extraordinary” means not normal. Surely using the same policy over and over again, in ever larger amounts, means that QE really isn’t what it’s hyped up to be?
What then does this say about markets and policymakers? Doing the same thing repeatedly expecting different outcomes, and all that jazz.
This Collection is our effort at dispelling the myths surrounding QE by starting from the ground up. We cover the basics of how the banking system works, the basics of how QE works, and then why it doesn’t work. All of which is a build up to an exploration of the truly fun question:
What happens to all of the things they said would happen because of QE?
in theory, the Fed’s MBS purchases should be the main driving factor behind high housing prices, but is that the case in reality?
Or is some other factor driving today’s red hot housing market?
Let’s take a look at where it all begins – banks making mortgages.
From the chart below, it is obvious that in terms of making new mortgages, Covid didn’t slow mortgage lenders down at all.
While the total amount of mortgages are now higher than they were before the Great Financial Crisis, YoY growth rates are nowhere close to what they were in the leadup to ‘08.
That being said, growth rates are at the highest they have been since the 2nd quarter of ‘08, when the crisis started to pick up steam.
This is mirrored in the data for Agency Mortgage Backed Securities (MBS) issuance.
From the chart above, you can see that since March ‘20, issuance of Agency MBS has roughly doubled, from ~$170 billion to a high of ~$385 billion in April ‘21, falling to about $300 billion in May.
Issuance has been above $300 billion for 11 consecutive months now, beginning in July ‘20. If June’s figures also come in above 300, that would make a full year.
For context, year to date issuance from Jan to May in 2021 stands at about $1.7 trillion, which is equal to the entire amount issued in 2019!
Is it any wonder then, that the housing market in the United States is booming?
The chart above quite clearly illustrates the pandemic boom in US house prices, at least when seen from the national level, with the index at record highs and YoY growth rates back at pre ‘08 highs.
Whether this is a bubble or not, as well as what risks this massive run up in house prices pose to financial stability is another discussion, but whatever one thinks about these issues, it is obvious that something changed at right about the time of the onset of the pandemic.
That something is the Fed, or more specifically, the Fed purchasing MBS as part of their latest round of QE, implemented to “stimulate” the economy back to growth.
As the rightmost highlighted area of the chart shows, the rise in housing prices over the past year has coincided with the Fed’s purchases of MBS.
This relationship is corroborated by the increase in total mortgage lending (from all lenders) and the increase in Agency MBS issuance over the same period of time, as illustrated in earlier charts.
However, it is important to note that MBS purchases alone do not lead to a stronger housing market.
A good example is when the Fed first started purchasing MBS as part of QE 1, way back in 2009. This period of time is highlighted on the leftmost portion of the chart above, and quite clearly shows that a spike in the Fed’s MBS holdings did nothing for US national house prices.
The reason for this can be found in the chart of US Total Mortgages at the beginning of this article, where mortgage lenders were cutting back on making new loans between 2009 and 2014. Drastically so in 2009 – 2010, when QE 1 was implemented.
Also, looking at the years between 2014 and 2018 (the highlighted portion in the middle of the chart), we see that house prices increased even as the Fed held its MBS holdings steady, to the point of letting them fall in 2019.
Again looking at the chart of Total Mortgages, we see that this period of time is when lenders started to increase their mortgage lending from off their post ‘08 lows.
Consequently, mortgage lending is a more important driver of house prices than Fed MBS purchases.
We are currently seeing record highs in the national home price index as this round of MBS purchases were, crucially, implemented during a period of time where mortgage lenders are growing their loan volumes.
At the end of the day, it always seems to come back to bank lending over central bank intervention, doesn’t it?
To be continued…
As record US housing prices fuels talk of another housing bubble and growing calls for the Fed to end its MBS purchases, an important development has been overlooked.
That is, amidst all the clamor, banks are making mortgages, but are unwilling to hold on to them.
What are the implications of this?
As shown previously, mortgage lending has been growing at an increasing rate over the past year, and at a level that is the strongest since the 2008 financial crisis (13 year highs).
While growth rates are still far below what they were in the lead-up to the crisis, the total amount of mortgages in the financial system has surpassed its pre-crisis high.
All of which makes sense given how quickly, and by how much, US house prices have risen over the course of the pandemic.
However, there has been a shift in banks’ underlying behavior with regards to the mortgages that they make, which could signal a growing sense of caution, or maybe even outright risk aversion.
At the beginning of the pandemic, banks were willing to make new mortgages and keep them on their balance sheets, which can be observed in the chart below, where total mortgages held by US banks continued to move higher.
This continued until sometime in the third quarter of 2020, when banks began to hold less of the mortgages that they were originating.
We know this because as the first chart illustrates, total mortgages over the course of the last 12 months have continued to increase, which means that the banks were still making mortgages, they were just offloading them to someone else as quickly as they could.
This is further demonstrated by falling growth rates in the chart above.
The amount of mortgages held by US banks on their balance sheets has grown at sharply slower rates over the past six months, turning negative in the first quarter of 2021 for the first time since 2013.
Comparing total mortgages held by US banks and Government Sponsored Enterprises (GSEs), we can see that in the previous 2 quarters (4Q 2020 and 1Q 2021), the amount held by banks began to dip, while that held by GSEs began to trend higher.
Growth rates illustrate this even more clearly, with the rate of growth in banks’ mortgage holdings decelerating sharply in 4Q 20 and 1Q 21, while that of GSEs accelerated sharply.
To be concluded…
Clearly US banks have not been very keen to hold on to the mortgages that they have created, instead offloading them to the GSEs.
While this isn’t surprising per se, since the Fed is still quite aggressively purchasing Agency MBS, what is noteworthy is how much the pace of this offloading has accelerated over the last 6 months.
What could this mean?
As the GSE chart shows, the total amount of mortgages held by GSEs is increasing at the fastest rate in a decade!
A bank unwilling to hold on to a mortgage suggests that, on a risk adjusted basis, they’d prefer to not participate in the loan’s upside, which implies that they see a higher than normal chance of the loan becoming impaired.
In other words, a bank is happy to offload a mortgage to someone else because they think that they will make more money by doing so, as opposed to collecting the interest it generates but exposing themselves to the risk of default.
This raises a number of concerns, not least of which is the strength of the US housing market.
Considering that banks choosing not to hold on to mortgages that they have made signals some level of reluctance on their part to be exposed to US housing, is the market really as strong as recent price increases and headlines suggest?
More importantly, if banks are selling their mortgages out of concern over whether borrowers can actually repay them, what does this say about the state of the current economic recovery?
Even as headline inflation numbers cause hysteria and job numbers continue to improve, it is easy to forget that US yields are hinting at an outcome that is more stagflationary than inflationary, and that the US labor market recovery is still very nascent.
Should the economy continue on this trajectory of recovery but not robust growth, banks offloading their mortgages to GSEs could quickly devolve into banks drastically slowing down their pace of mortgage lending.
If this happens, whether or not the Fed purchases MBS or not becomes irrelevant, as demonstrated by the years between 2009 and 2018, where MBS purchases did not alter banks’ lending behavior.
Finally, it is also worth pointing out that all of this is occurring even as the US government and the Fed have spent trillions of dollars in fiscal and monetary stimulus.
Perhaps, instead of focusing on whether or not the US housing market is in another bubble, it would be more constructive to question why fiscal stimulus is not as effective as everyone likes to think it is. Not to mention, does QE actually work?
We know that QE does not work because reserves are not lent out.
Why then the massive bull markets in these assets?
First, and most importantly, as mentioned many times before, is Paradigm. Belief is a powerful force that shapes our thinking after all.
But, is paradigm really all there is to how markets trade?
Of course not.
Paradigm is simply the spark (albeit a very powerful spark) that gets people brave enough to start buying financial assets again after a frenzied selloff.
This is especially relevant in the era of the central bank, where market participants have, over the years come to firmly believe in ideas such as the “Greenspan Put”, that became the “Fed Put” after Alan Greenspan’s retirement.
Initial buying based on participants’ belief in central bank action begets more buying, pushing prices higher.
Rising prices force shorts to cover, which further fuels the nascent rally, and “market recovery” narratives, previously whispered, are now discussed more openly and with increasing conviction.
Optimism grows, drawing in previously skeptical buyers.
Also, banks and brokers start feeling comfortable taking counterparty credit risk again, making credit more widely available. This allows folks with access to credit to borrow and leverage purchases, especially in markets where leverage is crucial to purchasing assets, like real estate.
Asset prices remain elevated while the economy catches up, giving enough “fundamental” support to asset prices. For example, a sustained period of strong corporate earnings that gives analysts, the media, and market participants a nexus to construct bullish narratives around.
At this point, ebullience is in vogue, and bearishness is treated with cries of “broken clock!” – in other words, a proper bull market.
Ultimately, all of this comes down to confidence, simply because modern capitalism runs on confidence.
In the case of traders and investors, they have come to place an increasing amount of confidence in central banks over the last few decades, even as central bank policy has evolved to the point where intervention is now the norm.
Consequently, the markets’ perceived omnipotence of central banks’ action has come to dominate their paradigm and narratives.
Just as it is with markets, confidence is crucial in the real economy.
Businesses must be confident enough in their future prospects to take out new loans to expand their operations, thereby creating new money in the economy. Corporations must be confident enough in the state of the global economy to expand business lines, engage in product development, and hire more people.
Of course, the financial markets and the real economy are interrelated parts, and what happens in one can feed into the other.
However, this relationship can at times blow hot, and at other times blow very cold.
An excellent example of the former is the bull market leading up to the Great Financial Crisis of 2008, where both asset prices and the economy grew strongly.
Confidence, however, takes time to build, much longer than it takes to be lost.
Considering QE’s failings, perhaps that’s the secret ingredient to bull markets and strong economies – time.
Time for confidence to recover, time for balance sheets to be repaired, and time for counterparties to rebuild trust and do business together again.
QE doesn’t work, at least not in the sense of fulfilling its objectives as a policy choice.
These would be, broadly, higher economic growth, higher employment, and higher inflation (the good kind).
In short, QE is supposed to be a monetary bazooka that does magical things. Instead, it’s been more magical thinking, not doing much good, while creating serious unintended consequences and second order effects.
Would it be better for central banks to just not do anything?
Doctors have a term for this, iatrogenesis, quite possibly first introduced into the financial lexicon by Nassim Taleb in his book “The Black Swan”, which describes QE’s effects very well.
Iatrogenesis, in the medical context, simply means the causing of a disease, complication, or negative effect by any medical activity. “Any” here encompasses the full suite of actions doctors may or may not take, from diagnosis, intervening action, making mistakes, or simple negligence.
In other words, it’s about taking action and having things not work out because of that action.
It is important to note that there is often a long chain of events between action and unforeseen/undesirable consequence, where different decisions could have been made to change the course of events.
But, there are also instances where the consequences can be quickly and directly traced back to the initial action, and QE falls firmly into this category.
QE actively makes the repo market unstable with all sorts of nasty, and more importantly, global, consequences.
By purchasing USTs, the Fed removes the primary form of collateral used in the repo market, which increases the probability of a collateral squeeze. Should markets be overly leveraged and overly bullish, such a squeeze has the potential to quickly snowball into mass liquidations which cascade through multiple asset classes globally.
Also, since the majority of market participants believe that QE is magical, they are predisposed to being overly bullish when a central bank announces yet another iteration of QE.
It’s almost as if policy makers want to set the system up for fragility and future failure.
Take a moment and consider the ramifications of this – that 1) Central Banks do not understand how money is created and how the financial system actually works, or 2) they do understand it but are not tailoring their policies to reality.
If 1) is true, then what good are these QE loving Central Banks doing?
If they do not understand the very basics of how the system they are overseeing works, that means that all their future monetary policies are dead on arrival, not to mention the decade(s) already gone.
On the other hand, if 2) is true, then it begs the question – Why?
A possible reason is that Central Banks feel the need to be actively doing something, which is after all a very normal emotional reaction all humans have in times of crisis.
Which brings us back to iatrogenesis.
Taking action because one feels that one needs to take action, or even worse, because one doesn’t want to be perceived as not taking action, surely counts as a poor reason for doing so.
This is especially the case when considering that QE doesn’t do much good, but still causes debilitating second order effects (e.g. reducing repo collateral).
The risk-reward of the policy is clearly off, so why persist with it?
Wouldn’t it be better for central banks to simply not do anything, at least until they figure out a course of action that is, at the very least, not harmful?
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