27th September 2017

Rathbones weekly review: The Prince(cess)

The conciliatory speech should clear the way for more constructive dialogue over the coming months. Mrs May outlined a wish for a transitory agreement that would keep the landscape steady for roughly two years following Brexit. That would include continued payments to the EU budget, remaining in the European Court of Justice’s jurisdiction and allowing the free movement of people to and from the Continent. Noticeably absent was the threat of walking away from a deal and building a tax haven economy.

A difficult middle ground it is to tread: to be both the lion and the fox, to avoid the traps set by the EU and to scare off the wolves that lurk within your Cabinet.

Sterling fell slightly following Mrs May’s speech, but the response from both sides of the Channel has been broadly complimentary.

Meanwhile, German Chancellor Angela Merkel’s CDU won almost 35% of the seats in Sunday’s federal election, about 13 percentage points higher than its closest rival, the SPD. It was the worst electoral result of Mrs Merkel’s 12-year leadership. The right-wing Alternative für Deutschlandpicked up 94 seats in the parliament, or 13% of the total, making it the third-largest caucus in the Bundestag. The spread of seats means there are several options for the socially conservative and economically liberal CDU to form a government. They may continue with the grand coalition with the social-democrat SPD which formed the last government, or they could drop them in favour of an alliance with the Green Party and the centre-right liberals, the FDP.

The global election season of 2017 has been extended, with Japanese Prime Minster Shinzo Abe announcing this week that the government will be dissolved ahead of an election on 22 October. Mr Abe has been riding high in the polls after some months in the doldrums. Heightened tensions with North Korea can’t hurt him either: Mr Abe is a committed nationalist who has long argued to boost his nation’s armed forces. Japan is banned by its post-Word War II constitution from having a standing army, although it has a technologically advanced “Self-Defense Force” that eschews offensive weapons, such as bombers, aircraft carriers and long-range missiles. 

Source: FE Analytics, data sterling total return to 22 September

Bookkeeping

After years of printing new acronyms and money, the US Federal Reserve has finally unveiled its plan for unwinding quantitative easing (QE).

In the aftermath of the financial crisis, the Federal Reserve (Fed) used a series of unconventional steps to lower the cost of risk and thereby boost demand to prevent a repeat of the Great Depression. Once it had rapidly cut interest rates as close to zero as it was willing to go, the central bank started printing money which it then used to buy bonds and mortgage-backed securities (MBS) on the open market. The aim was to free up commercial bank balance sheets, allowing them to lend again, while simultaneously reducing the cost of borrowing further. It worked, but like all fixes it became addictive. By the end of it, the assets on the Fed’s balance sheet had ballooned to $4.25tn. Before the crisis, that number was just $750bn.

Now, it will decrease its holdings of treasuries by $6bn for each of the next three months, stepping up to $12bn for the next three, then $18bn, and then $24bn, finishing at $30bn where it will remain steady till they are “all gone”. At the same time its stock of MBS will fall by $4bn, going up in equal increments till it holds steady at $20bn a month. At that rate, all the securities would be disposed of by 2025.

Now, the reason why we say “all gone” in inverted commas is because it’s impossible for this to happen. The Fed, powerful though it is, remains a company tied to the hum-drum reality of double-entry bookkeeping. Its liabilities have to match its assets. At its simplest, the liabilities of the central bank is the currency in circulation. That is matched by its assets of treasuries, MBS and other securities. One other liability on the Fed’s books is the cash banks hold in reserve accounts at the Fed. That currently stands at roughly $2.4tn; it was only a few billion before the credit crunch. Most of this meteoric rise can be put at the door of QE: when the Fed created money to buy securities from the banks, the banks deposited the cash at the Fed because it offered a better, risk-free, interest rate than they could get elsewhere. The Fed has no idea whether these balances will go up or down once it starts selling assets.

What does all this mean? Because the Fed’s assets can’t fall below the value of its currency in circulation, the Fed would likely be able to rid itself of only about 65% of its securities – possibly even as little as 35% – according to our calculations. If it cut back on 65% of its assets, we believe that would push yields between 68 and 154 basis points higher over four years, all else being equal. That’s with the assumption that tightening and easing should have a symmetrical effect on bond yields.

That is less potent than the three 0.25% rate hikes forecast for 2018 by the Fed in the same announcement as its quantitative tightening programme. To us, this gradual – and partial – unwinding doesn’t seem like something to fear.

Bonds

UK 10-Year yield @ 1.36%

US 10-Year yield @ 2.25%

Germany 10-Year yield @ 0.45%

Italy 10-Year yield @ 2.17%

Spain 10-Year yield @ 1.63%

Julian Chillingworth
Chief Investment Officer

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