The great QE unwind is coming

After ending quantitative easing in 2014, the Federal Reserve now plans to begin shrinking its balance sheet over the next several years by tapering the reinvestment of its Treasury and mortgage-backed security holdings. During the same period, U.S. deficits are projected to grow substantially – notwithstanding the possible enactment of any of President Donald Trump’s major proposed legislative initiatives, which would likely cause deficits to swell even further.

Increasing U.S. deficits will require the Treasury to ramp up bond issuance. As a greater risk premium will be required to attract new buyers to absorb both the U.S. primary deficit and the Fed’s reduction in its holdings, the U.S. yield curve is likely to steepen. Price concessions into Treasury auctions will likely increase as well.

The European Central Bank, for its part, is increasingly expected to begin winding down its QE program in 2018. This is likely to bring steeper European yield curves, putting additional pressure on the U.S. curve to steepen further.

By communicating the end of QE in advance and increasing the rate of reduction gradually, the Fed hopes to avoid the “taper tantrum” that roiled markets from 2013 until early 2016, when U.S. equities, and global assets more generally, were subject to periodic risk-off episodes.

The aim of QE was to push flows into more productive investments – not just financial assets. Unfortunately, evidence for increased economic activity from QE is relatively weak.

Yet QE did have an impact. It artificially flattened yield curves, weakened the country’s currency, allowed poorly performing companies to roll over debt and inflated asset prices.

By depressing yields on government securities, QE encouraged yield-seeking behavior. Many analysts note that the growth of central bank balance sheets has been eerily correlated with the increased value of global risk assets and U.S. equities.

In June, the Federal Open Market Committee raised interest rates by 25 basis points for the third consecutive quarter. The Fed did so, based on internal Phillips curve models, which predict that low levels of unemployment lead to increasing inflation. As the Fed starts to implement its balance sheet runoff, it may find it increasingly difficult to maintain its rate hiking cycle.

Balance sheet reduction is likely to commence in the fourth quarter for both U.S. Treasury holdings and mortgage-backed securities. The combined maximum rate of reduction is $10 billion a month but rising incrementally to a maximum $50 billion a month by the fourth quarter of 2018.

While the Fed has previously tapered its purchases, and in fact ended purchases for brief periods twice, neither it nor any other major central bank that has engaged in QE has actually tried to shrink its balance sheet thereafter. What’s odd is that the Fed and other central banks have made claims about the efficacy of QE, but when the policy goes into reverse, they seem to think there won’t be any meaningful effect.

The Fed says it hopes the process will “run quietly in the background” and not amount to policy tightening. We shall see. I believe that Fed balance sheet shrinkage could have substantially greater effects on both bond markets and financial markets, generally, than conventional interest rate increases.

Since QE purchases ended, the Fed has continued to reinvest the coupon and principal payments of both Treasuries and MBS holdings. Starting in October, the Fed will likely reduce reinvestments of purchases of Treasuries by $6 billion a month, while reducing MBS reinvestments by $4 billion a month.

In 2018 the Fed will allow up to $180 billion of Treasuries and up to $120 billion of MBS to run off. Thereafter, it will allow up to $360 billion of Treasuries and up to $240 billion of MBS runoff.

This is likely to come against a backdrop of a rising U.S. deficit, which is projected to rise to more than $1 trillion by 2022 (vs. $500 billion in 2015). These projections, moreover, do not include the possible enactment of any of President Trump’s likely deficit-raising policies on fiscal spending, defense increases, infrastructure spending or tax cuts.

In the Treasury market, increased supply at auctions will grow steadily throughout 2018, which will likely result in significant yield curve steepening. Rather than being used as a liquidity point for investors to buy large quantities of bonds, Treasury auctions will be more difficult to digest.

It is therefore likely that as net new issuance increases (accounting for the reduction in Fed purchases), we will see significant stress and concessions into Treasury auctions. This will coincide with the Congressional Budget Office forecasts of net funding needs approaching, or even exceeding, the levels that existed in 2009 and 2010.

After years of financial repression, with yields at historic lows and financial institutions on much firmer footing, and with an upturn in global synchronized growth, appetite for government securities is waning. Hence, we expect to see a steeper yield curve and wider MBS spreads.

More importantly we expect to see substantially more difficulty for the U.S. and European governments to issue debt at auctions and syndications. We might even see bond market vigilantes start to impose fiscal discipline on the U.S. government.

By SAID N. HAIDAR

Real Talk with Said Haidar of Haidar Capital Management

Today, Finalternatives sits down with macro-fund manager Said Haidar. His firm Haidar Capital Management is a catalyst driven niche/tactical global macro fund with a systematic component. The firm has $314 million in assets under management.

In a one-on-one interview, Haidar offers insight into the ongoing challenges in the European economy, the future of the euro, and what a possible crisis that is emerging that has been ignored by the North American media.

FINalternatives; What is Your Background?

Said Haidar (SH): I manage a global macro book heavily involved in global rate markets, including European governments bonds and European interest rates. We closely follow central bank speeches, meetings, and leaks to the press, as well as dealer commentary to understand the current thinking and reaction functions of central banks. Earlier this year I met with the Bundesbank and the European Central Bank to hear their views.

Fin: Given Macron’s election, what does that mean for the future of the euro? Given Marine Le Pen’s loss, what does it mean for the future of populism on the continent?

SH: Unlike with Brexit and the Trump victory, continental Europe has shown itself resistant to the siren call of the populist , with the exception of the Syriza victory in Greece. In Spain, Podemos was turned back. In Austria, the far-right presidential candidate lost to the Green Party. In Holland, traditional right-wing parties stole the thunder of Geert Wilders’ Peoples Party. France was no exception, where Marine Le Pen’s National Front faded as well in the final stretch.

The next major election involving a populist party will be in Italy in spring of 2018 where Beppo Grillo’s Five Star Movement appears on track to have a shot as Italy’s largest party. While populism has been staved off for now, keep in mind that Marine Le Pen’s father polled at just 18% in 2002, while Marine received 34% of the vote. Most voters are reluctant to back the National Front, given its promise to withdraw from the Eurozone. However, if there is another recession in Europe, it’s possible that more French voters might switch to the National Front in 2022.

Fin: Joseph Stiglitz has said that the Euro threatens the future and stability of Europe? A lack of structural reforms sits at the center of his argument. Do you agree that it is flawed to have one central monetary policy but 28 different fiscal policies across the continent? Do you have other concerns about the currency’s future? Do you believe it can be saved?

SH: A well-known problem is how to exit the common currency without bankrupting a country’s banking system and corporations. A country like the Netherlands could probably successfully leave, as a new Guilder would likely appreciate against the Euro. However, those countries which are expected to have a weak currency, would see wholesale capital flight ahead of any exit. This was the problem with Le Pen’s plan to leave the Euro.

A currency union where each participant is a sovereign government can lose members as soon as an anti-Euro government is installed in one. An ideal currency union needs to have elements like the free mobility of workers. While technically feasible, Europe’s language and cultural barriers are too great to imagine wholesale migration of people. A one-size fits all currency with poor labor mobility, no inter-state transfers that forces the weakest members to make all the adjustments while Germany earns the benefit of a weak exchange rate, seems one that is ultimately unstable.

Anticipation of a country exiting can put enormous pressure on that country’s government bond market and banking deposit system.

Fin: There is an odd perception here in the United States — we’ve heard some people say that Greece is holding the European Union hostage for another bailout. We’ve watched Greek visitors in Chicago get into arguments with people explaining that austerity is the real problem (and we agree with the people who actually live there).

SH: The Greek bailout did enormous damage to private creditors, as money lent by public creditors was treated as senior to that of privates. The more lent by public creditors, the less recovery was to be had by private creditors. Greek austerity in the early years involved draconian legislation that failed to carry out measures. As a patronage state, Greece overrode other interests and prevented implementations. They shuffled workers between state-owned enterprises but did not really fire anyone and failed to seriously address rampant tax fraud by politically-connected Greeks. However, there was massive pain for ordinary Greeks, with one of the greatest economic contractions for a developed country in modern history. As the economy contracted and missed targets, the hated Troika demanded more cuts.

European economic austerity programs have been designed around hefty tax hikes and cuts to those most vulnerable (e.g. in Greece, large cuts to pensioners). These have exacerbated the situation. Where measures have focused on liberalization of labor markets and reduction in public sectors, results appear to better. In practice, no bailout by its European “partners” would have been far better for Greece and its private creditors. Greece would have been forced to immediately live within its means, as its access to credit curtailed after default.

However, Greece would have started with a new Drachma on a more competitive basis and the state could have recapitalized banks with the new currency. Private creditors, not being subordinated to public creditors, would have likely fared better.

Fin: What has been the result of austerity? Do you expect the European Union to issue a much larger bailout to paper over the nation’s debts?

SH: Greece, with a high debt to GDP ratio, has low interest expense and, assuming a smooth completion of the latest review, will likely be offered a re-profiled debt, with interest payments pushed further out.

Fin: While Greece and Italy are generating the headlines, Spain, Portugal and Ireland also have debt concerns? Which one do you think will be the next shoe to drop?

SH: The perception is that Ireland is fast repaying its debt. Very little remains of the bad bank liabilities and Ireland is projected to have one of the lowest debt to GDP ratios in Europe over the next few years.

Spain is favored by investors, as it finally took sufficient measures to liberalize labor laws, reduce state pensions and has enjoyed strong growth. Weaknesses include a separatist movement in Catalonia (which seems to be losing popularity) and a minority government that keeps missing its EC budget targets, as it has been less successful in reigning in spending by regional states. If growth remains strong, investors will stay positive on Spain.

Portugal has been the surprise of 2017, substantially tightening vs Italy as growth has picked up, budget execution has been stellar and banking problems have failed to hit home as feared. Portugal has wisely used its market access to pay down the very high cost of an IMF loan. The market seemed to be overly negative on the left-wing government’s policies. Portugal kept its budget in check by deferring infrastructure spending (borrowing from the future) and raising taxes on investments, while maintaining entitlements. It also singled out foreign bank debt holders for discriminatory treatment. There are still large nascent banking issues that could throw Portuguese market access into turmoil. Portugal’s fate depends on how these play out over the next few years.

Italy’s reforms have been stalled and little was accomplished during Renzi’s administration. We suspect a key reason for the ECB to taper QE will be to force Italian bond spreads wider to put pressure on Italian politicians to finally act and liberalize their economy. Despite the strong European economy, Italy has singularly failed to grow. Compounding Italy’s problems is the continuing inability by Italy and the EC to agree on how to recapitalize parts of the Italian banking system. As QE winds down and Italian spreads widen, Italian politicians will be faced with a conundrum: to act or watch spreads widen further. At some point, Italy will need to decide whether to act decisively to liberalize its market (and the EC will need to act decisively to assist Italy in recapitalizing its banking system) or consider dropping the Euro, as its interest costs will start to rise unsustainably.

Fin: The financial press has a terrible happen of identifying crises until they are sitting on top of us. Are there any threats that no one is discussing that is on your radar?

SH: One threat is the Home Capital saga in Canada. The extremely low interest rates along with massive QE in certain countries has led to imbalances in asset markets around the world. Both Canada and Australia appear to have housing bubbles in large metropolitan areas, with many borrowers who have little ability to meet rising interest rates. Moreover, much like the US mortgage market in the 1930s, commonwealth countries tend to have mortgages with long amortization schedules, but balloon principal payments every 5 years. When principal payments need to roll over, and if the collateral house value has declined, the homeowner needs to put up extra cash.

A failure to roll over the mortgage will lead to a default. As housing prices fell in the US during the early 1930s, millions of homeowners lost their houses, despite being current on their mortgages, as they were unable to roll over their mortgage. I see no reason why a similar dynamic could hit one of these countries. In a declining property market, even many prime loans could be impacted and the banking sectors would suffer significant damage.

Fin: Looking ahead, where do you see opportunity in Europe for institutional investors? Is there a country or individual sector that intrigues you today?

SH: European assets appear undervalued relative to US assets. Years of underperformance seem to finally be at end. However, investor caution has been caused by a series of political events, starting with Brexit and its on-going negotiations, the Dutch and French elections, the upcoming French parliamentary elections as well as the Italian elections (although this might take place in 2018).

Eliciting additional caution is how leveraged Germany is on Chinese growth (which has held up remarkably well with some state support) as well the headlong rush into European equities in 2014 and 2015 in anticipation of a major re-rating due to European QE. However, it was too early in the economic recovery cycle and European equities disappointed on earnings growth. This was followed by Yuan devaluation scares in August 2015 and early 2016, which caused a large, painful unwind in these trades. Hence, while many profess to be bullish European equities, we believe positioning is still light. And European equities have finally started to show strong earnings growth, as European growth has improved. The European banks still appear quite cheap compared to US bank valuations.

As for fixed income assets, strong growth and a more traditionally monetarist approach from the ECB as opposed to the Fed, leads to expectations of a taper of QE from the start of 2018. Just as in the run-up to Eurozone QE, where we saw yield curves flatten and spreads compress, we expect the reverse in the run-up to the taper, with modest spread widening at first and modest curve bear steepening.

Banks come in from the cold for hedge funds

Bank stocks are back in vogue for hedge funds, which have shunned the industry over the past seven years due to a squeeze on banks’ profitability from low interest rates and because of their opaque balance sheets. Haidar, which is long banks globally, notes European banks look cheap and that profits could improve now interest rates are on the rise in the United States and ultimately could rise in Europe too.

Read the article online here.

 

Europe’s Periphery Debt Market Welcomes New Member: France

Investors are once again selling the bonds of Europe’s peripheral economies amid political concerns. “Without ECB support it’s hard to see how their spreads don’t widen up further,” according to Said Haidar, chief executive of Haidar Capital Management. Haidar is now betting against Southern European and French bonds.

Read the article online here.

French bond trading soars on fear of populist wave

French bonds are being traded at volumes not seen since the eurozone crisis as the tumultuous presidential election race has divided investors over whether France will deliver the world’s next populist upset. Hedge funds in New York say investors are becoming increasingly concerned at the possibility that far-right candidate Marine Le Pen, whose National Front party has pledged to pull France out of the euro, will win when voters go to the polls in late April. “It’s hard to see Le Pen win, but no one’s trusting the polls after Trump and the Brexit referendum,” said Said Haidar, chief executive of Haidar Capital Management in New York.

Read the article online here.

Hedge funds head back into government bonds after turgid 2016

Some hedge funds who shunned or bet against European government bonds only three months ago are buying again as a sharp rise in yields offers them returns after a lacklustre 2016 for the industry. Said Haidar, founder and CIO at Haidar Capital Management, said government bond sales via syndication may offer short-term tactical opportunities to buy bonds. Haidar bought into France’s inaugural Green bond and Italy’s 15-year and Spain’s 10-year. “We think this steepening in European bonds is going to continue because people are going to anticipate the end of quantitative easing programmes,” said Haidar.

Read the article online here.

Global Stocks Climb as Dollar Rally Resumes

European banks – one of the biggest gainers from the global equity rally at the end of 2016—were up by more than 2.6%. “If the legal liabilities that have plagued banks are nearly over, the Italian banks are in the process of finally getting fixed and capital requirements are close to being met, we could see 2017 as the year of banks globally,” said Said Haidar, CEO of Haidar Capital Management.

Article available through Dow Jones Newswires. 

Opportunities Seen in Europe’s Banks, Rates on Region’s Messy Politics

The wave of populism across Europe has further to run, creating investment opportunities in financials and rates, according to Haidar Capital Management. Said Haidar notes that a Le Pen victory would be the “beginning of the end of the euro” and that the firm is positioned long European banks, “which trade at very low valuations to book and have been one of the beneficiaries of higher yields and steeper yield curves.”

Hedge fund wins big from betting on QE bond buying

Haidar Capital has generated double digit investment returns this year as it targets distortions in government debt markets caused by central bank bond buying. The firm’s $300m fund has been employing a highly leveraged trading strategy to take bets in advance on bonds that it believes the European Central Bank and Bank of England intends to buy.

Read article online here.