Cause and effect this week covered a wide and improbable range.
Perhaps the most important actual, real fact arrived on Monday, before the nation scattered its marbles altogether: the economy is fine. July retail sales jumped .6%, double the forecast, and without any phony boost from auto sales fueled by subprime lending. June retail sales were revised up, and year-over-year sales have risen 4.2%.
Despite that excellent result, by early this morning the 10-year T-note fell below 2.20% for the first time since June, and that the first time since last November. Causes: an overdue fainting spell in the stock market and political chaos. No-point mortgages are approaching 3.875% -- not even today’s defenestration of Steve Bannon has relieved political tension and produced a ”relief rally” upward, rates and stocks still down.
Instead of attempting a forecast of political effects on markets (see concluding addendum), take on something simple: the mechanics and market and economic effects of the Fed’s reversal of quantitative easing (RQE) to be announced in September and begin before year-end.
Bill Dudley, president of the New York Fed and proxy for Chair Yellen said on Monday, “We’re probably going to see a balance sheet five years from now that’s probably in the order of $2.5-$3.5 trillion rather than $4.5 Trillion.”
The dreaded double-probably aside, and converting Dudley to workable arithmetic... the Fed is going to unload $1 to $2 trillion of Treasurys and MBS over five years. That would be a range of $17 billion to $35 billion per month. The cumulative size of Treasury and mortgage markets: $25 trillion. Big.
The greatest concern to housing of course is damage to mortgage rates. However, the Fed’s total holdings of MBS are $1.6 trillion; even at the Fed’s outsize number for shrinkage, assuming some balance between Treasury and MBS runoff, the Fed will unload only about half of its MBS holdings over five years, one-half the pace of initial purchase.
Wall Street fright-mongers are already raising the alarm: this will be a shift to “quantitative tightening” of bank reserves and the money supply, and a shock to Treasury and MBS markets. Here follow the reasons to reject that view.
First, the Fed will not sell its holdings. During this whole QE period, since January 2009 whenever a Treasury or MBS which it has bought has matured, the asset extinguished and cash flowed back into the Fed, the Fed has “reinvested” -- bought more of the same asset which has matured. Beginning sometime this fall the Fed will trim its reinvestments. As assets mature and cash arrives, the Fed will reinvest only a portion, resulting in a net decline in the size of its balance sheet -- but no direct sales of anything.
What portion? Stick with Dudley-math. The Fed’s own communication is awful, describing a “cap” on a drawdown when they mean a floor. Maturities of Treasurys are known -- each bond, note, and bill has a maturity date. Thus the Fed can anticipate exactly the amount of Treasury runoff to divide between continuing reinvestment and cash retained in favor of net reduction of Treasurys.
MBS on the other hand are a black art. The blackest of arts on Wall Street is forecasting the rate of prepayment on MBS pools. The mortgages inside MBS prepay 1) when homes sell, 2) when owners refinance, 3) by amortization, and 4) when crazy people send in extra principal. Number three is predictable, the other three... not. The rate of prepayment in Street slang is known as “speed.”
Skip to conclusion: MBS RQE will be self-correcting, offsetting shocks. If rates fall and refis boom, speed increasing, the Fed will keep RQE on net schedule by increasing reinvestment -- a floor under runoff. If rates rise, and refis and sales and speed falling, the Fed will have less cash and make fewer reinvestments, but net runoff will be the same.
The other elements of worry: first, when the Fed receives excess cash over reinvestment it will pay down bank reserves which it created when it bought the Treasurys and MBS from banks in the first place. The people today who worry about a tightening effect are the same as those who warned that QE would ignite credit creation and inflation. Oh-for-2. The bloated bank reserves and money supply created since 2009 have been secured in mayonnaise jars under the porches of banks, inert, coming and now going.
The Fed’s purpose in QE was not a traditional reserve/money operation. Bernanke understood quickly that a broken banking system could not create credit no matter how packed with excess reserves. The purpose of QE was direct injection of credit into the economy around a broken banking system. The Fed stopped adding to its balance sheet in 2014 as soon as it was clear that banks could generate credit. Today there is so much cash sloshing in the world (corporate balance sheets!) that business is self-funding its credit needs on net, and not bothering with banks (see minutes of Fed meeting July 26, page 4).
Which leaves the last concern: can markets absorb new MBS and Treasury production while the Fed gradually withdraws as a bidder? Nobody knows for sure, but if the Fed does damage it will reduce or stop RQE. Likelihood? One of the favorites of Wall Street charlatans is to scare the public via zero-sum closed-market boogeymen: more Treasurys and MBS, less Fed, rates must go up.
Not so. At any given moment, buyers and sellers are in balance. If a buyer withdraws, rates may rise a little or a lot depending on the size, depth, breadth, and liquidity of the particular market. The market for US Treasurys is the largest of any market for sovereign IOUs, and the highest quality. The MBS market is smaller, but rich in yield to compensate for unknowable speed of prepayment. The Fed owns only one-quarter of the $6.5 trillion agency MBS market, itself only two-thirds of all US first mortgages outstanding.
Says here that it will take very little increase in yield to attract buyers of other IOUs to the Treasury and MBS markets as the Fed enters slow RQE.
A political addendum follows. Those of tender sensibilities had better skip.
This has been a watershed week: the president’s behavior cannot continue. Not for his full term, nor even many months. Follow the decision tree....
Either he changes, or he goes, or the Republican party will suffer greater damage than any in our history. The odds against change are enormous; he is who he has always been. Odds of confinement and micromanagement by a team of regents are similarly low.
If he goes, he has choices. The ghostwriter of “Art Of The Deal,” Tony Schwartz who spent 18 months in close contact with him, tweeted last night: “Trump's presidency is effectively over. Would be amazed if he survives till end of the year. More likely resigns by fall, if not sooner.” Schwartz and many others assume that the intent of resignation would be to stop Mueller’s probe, and in exchange for a pardon. It is too soon to know about that; for all of the smoke there may not be actual wrongdoing and discovery for Trump to fear.
The second motivation to resign: to escape a second posse. Republican leadership in Congress is exceptionally hollow, souls sold in exchange for a majority. The Devil is a tricky fellow: Republicans got their majority, but Tea Party radicals are an iron bar stuck in the spokes of action.
This week, Congress still in recess, the Republican leadership finds itself way behind the country, which is a good place to be, if for cowardly and clueless reasons. In defense of the leadership, given a choice between suicide and regicide, better to follow than to lead.
This week, just this week: the CEOs of America’s best and largest corporations have rejected and fled the president. The chiefs of all five branches of military service messaged to their commands a rejection of the president’s statements about Charlottesville -- after completely ignoring the president’s order to ban transgender people from military service. in perhaps the strongest telltale, James Murdoch, CEO of 21st Century Fox, parent of Fox News wrote this yesterday: “I can’t even believe I have to write this: standing up to Nazis is essential; there are no good Nazis. Or Klansmen, or terrorists. Democrats, Republicans, and others must all agree on this, and it compromises nothing for them to do so.”
McConnell and Ryan will either be forced to lead a delegation to the White House to say “or else,” or the party will suffer even more. And the nation. Impeachment is unlikely, too awkward and in the absence of an identifiable “high crime.” Assisted resignation is most likely. But if the president refuses, the 25th amendment is available. Its linchpin and trigger man: VP Pence. Killers of kings are later rarely popular, especially if they assume the crown of the dead monarch. It would take real guts for Pence, and we don’t know if he has any. He wants the job but may be fussy about stepping over the body.
Now the good news: markets will soar upon Trump exit. Markets and the economy are at risk until then, not just the Republican party. Non-political godfather of the stock market, Art Cashin on CNN this morning: "If you had more than one resignation... Steve Cohn and Wilbur Ross -- I think it would have a very formidable effect — 500 or 1,000 points on the Dow possibly." Bad guys leaving do not help (see Bannon); the markets fear losing the good-guy regents, presently holding the government together and protecting us from the president.
In the days after Trump exits, markets will make book on president Pence, and Ryan and McConnell and their ability to move forward any useful agenda. But even if they cannot we’ll be in a far better place than today.
Here follows the entire text of the 25th amendment, paragraph four the operative one:
Section 1. In case of the removal of the President from office or of his death or resignation, the Vice President shall become President.
Section 2. Whenever there is a vacancy in the office of the Vice President, the President shall nominate a Vice President who shall take office upon confirmation by a majority vote of both Houses of Congress.
Section 3. Whenever the President transmits to the President pro tempore of the Senate and the Speaker of the House of Representatives his written declaration that he is unable to discharge the powers and duties of his office, and until he transmits to them a written declaration to the contrary, such powers and duties shall be discharged by the Vice President as Acting President.
Section 4. Whenever the Vice President and a majority of either the principal officers of the executive departments or of such other body as Congress may by law provide, transmit to the President pro tempore of the Senate and the Speaker of the House of Representatives their written declaration that the President is unable to discharge the powers and duties of his office, the Vice President shall immediately assume the powers and duties of the office as Acting President.
Thereafter, when the President transmits to the President pro tempore of the Senate and the Speaker of the House of Representatives his written declaration that no inability exists, he shall resume the powers and duties of his office unless the Vice President and a majority of either the principal officers of the executive department or of such other body as Congress may by law provide, transmit within four days to the President pro tempore of the Senate and the Speaker of the House of Representatives their written declaration that the President is unable to discharge the powers and duties of his office. Thereupon Congress shall decide the issue, assembling within forty-eight hours for that purpose if not in session. If the Congress, within twenty-one days after receipt of the latter written declaration, or, if Congress is not in session, within twenty-one days after Congress is required to assemble, determines by two-thirds vote of both Houses that the President is unable to discharge the powers and duties of his office, the Vice President shall continue to discharge the same as Acting President; otherwise, the President shall resume the powers and duties of his office.