Quantitative Easing in Reverse

August 9 2017

That the Federal Reserve would leave interest rates unchanged, was something even elementary school students could have expected. Yet the big question was: when will the central bank begin selling all those US Treasuries and mortgage-backed securities (about $4 trillion) which were purchased in the past few years?

Whereas the Fed as recently as last June said to begin reducing the size of its balance sheet, it provided more specifics last week. The central bank is now declaring that it will shrink its balance sheet “relatively soon.”

By financial markets, this was directly interpreted as “beginning in October.” At the end of September, the interest rate committee (the FOMC) will meet again and there happens to be a press conference afterwards, which is an excellent opportunity to announce the first sales of the Fed´s assets. The fact that the Fed has a press conference scheduled is not unimportant, since the Fed will want to explain every step toward a little less expansive monetary policy to avoid upsetting markets.


But beware: the promise to initiate relatively soon the sale of all those US Treasuries and mortgage-backed securities is a conditional promise. The central bank will only begin selling assets if the economy continues to expand at the rate the Fed expects it to.

In concrete terms, this means that economic growth is not allowed to slow down further, that the labor market must continue to show the same solid performance, and that inflation will not retract further. If growth weakens and/or US inflation will decline further, then it is rather questionable whether the Fed will tighten their stance as soon as in October.

And lower economic growth is a realistic scenario. Recently, the International Monetary Fund (IMF) revised down its growth forecasts for the US economy for this and next year. For next year, the IMF forecasters are no longer predicting 2.5 percent growth in the US, but 2.1 percent, which is a significant adjustment.

But let us assume that the IMF is too pessimistic and that US economic growth will not slow down. In that case, the Fed might begin with the sales of US Treasuries and mortgage-backed securities, but it will be keen to not disrupt markets and keep a close tab on the US economy.


The fact that selling these US Treasuries causes upward pressure on interest rates, is something we know. What is also implies, is that it is disruptive. A rate hike almost two months after announcing the start of asset sales in December, something which many analysts currently expect, might after all be akin to playing with fire. Especially as inflation does not begin rising again or even drops further in the US.

In recent months, the EUR/USD has risen substantially, from 1.11 to a little bit over 1.17, quite an increase in a matter of days. What is crucial for its future exchange rate, is the difference between what the Fed will do with interest rates and what the market expects the Fed to do. The latter amounts to four rate hikes between now and the end of 2018.

Any discrepancies in the sense that the Fed raises interest rates faster than is currently expected, would push the EUR/USD rate down. A discrepancy in the sense that the Fed ends up hiking rates less than four times, would on the contrary push the EUR/USD rate up. Personally, I think that the odds of San Marino and Andorra qualifying for the World Cup in Russia next year are higher than the odds of the Fed raising the interest rates more than four times before the end of 2018. The chance that the central banks raises rates less than four times – and not even once in the current year – is, according to my judgment, high.

No, I would not be surprised if the EUR/USD rate remains under upward pressure, especially because I suspect that the ECB is not unhappy with the temporarily stronger euro, as I recently argued in another article. We will have to wait and see if this will play out. If it plays out, then a logical outcome would be that gold prices will regain some lost ground. After all, a weak dollar is more often than not positive for precious metals.


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