QT - Mixed Dallas Manufacturing Fed Report

Before getting into QT or Quantitative Tightening, let's review the Philly Fed. Relatively speaking, the Dallas Fed report was solid because the Philly Fed report was negative and the Markit flash PMI fell. The production index was down 4.4 points to 10.1 and the general business activity index was up 12.1 points to 13.1. This beat estimates for 4.8 and the high end of the consensus range which was 11.7. The new orders index was down 4.7 points to 6.9. However, the growth of new orders index was up 2.2 to 3.4, capex was up 2.7 points to 18.7, and the company outlook was up 7.1 points to 14.2.  

QT - The outlook uncertainty index fell 11.5 points to 4.1. That’s good news as there was less uncertainty. 17.2% of firms saw uncertainty increase, 69.7% saw no change, and 13.1% saw uncertainty drop. The government shutdown ending and the China-America trade war cooling down probably helped this index fall. The rebound in oil prices probably helped this district which is a heavy energy producer. The Permian basin is in west Texas. The latest oil price is $56.90. It’s good to see oil prices rebound because it increases manufacturing activity and signals demand is solid. However, I don’t want to see oil get above $80 because it would be a big cost increase which would crimp margins.

The 6-month future estimates were also mixed as the production index fell 9.1 points to 44.3 and the general business activity index was up from 11.7 to 17.7. The new orders index was up 0.2 to 44.9 and the company outlook index was up 4.4 points to 26.7. However, the growth rate of new orders fell from 38.5 to 30.8 and the capex index fell 10.2 points to 24. As I mentioned earlier, a mixed report is solid considering the weakness we’ve seen in other manufacturing reports.  

The quotes are important because they tell us why this report was stronger than some others. A machinery manufacturing company stated, “We’ve had a solid start to the new year, and if Chinese trade negotiations go well and an agreement is reached in March, we think the economy will take off again.” A trade deal will definitely boost some areas of the economy. The quotes were all over the map as a machinery manufacturing firm stated, “we are hurting bad; we need work” while a textile product mills firm said, “business is booming, and our customer are writing bigger orders for a broader product assortment.”

QT - Strong Improvement In The Richmond Fed Index

The strong Richmond Fed index pushes the overall regional Fed estimate for the February manufacturing ISM PMI to the positive side. The Empire Fed and Dallas Fed readings were solid, and the Richmond Fed index was 16, which increased from -2. This beat the consensus of 3 and the high end of the estimate range which was 8. Only the Philly Fed index was very weak. The ISM PMI comes out on Friday. It is expected to fall from 56.6 to 55. I agree with the consensus. If the ISM PMI meets estimates, it would be slightly better than the Markit flash reading.

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The chart above shows the Richmond Fed index is very volatile. This implies the weakness in December and January could have been a blip. The shipments index improved from -8 in January to 12. The volume of new orders index was up from -11 to 19. Local business conditions were up from -11 to 4. Seven of the index’s business sector components were up, one stayed the same, and only three fell. The services expenditures index fell the most as it went from 6 to -4. The expectations indexes weren’t as strong as six increased and five fell. The biggest increase was vendor lead time which was up from -9 to 3. The biggest decline was services expenditures which fell from 8 to -4.

QT - Quantitative Tightening Breakdown Of The Fed’s Balance Sheet

Let me clarify the Fed’s balance sheet for those who were confused by Powell’s comments on Tuesday. Powell stated he thinks the balance sheet unwind will end when the reserve balances fall to about $1 trillion with a small buffer in place. That could be about $1.1 trillion.

As the chart on the left shows, there are about $1.6 trillion in reserve balances. As you can see, only the reserve balances are falling. Other Fed liabilities are stable and currency in circulation is rising. If currency in circulation rises about $100 billion by the end of the year, that implies the Fed’s balance sheet would fall by about $600 billion. If the unwind continues at a pace of $50 billion per month, that means it will end in Q1 2020. It’s possible the Fed gradually slows it down like how the ECB gradually slowed QE last year. In that case, the Fed’s QT program could end as late as Q4 2020.

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The Fed currently has $1.6 trillion in mortgage-backed securities on its balance sheet. The rest are mostly treasuries with a maturity date of less than 5 years from now. The Fed wants to get rid of all its MBS. If it allows them to mature, it will take over 8 years to get rid of them all. The other option would be to actively sell them.

QT - If the Fed maintains its balance sheet while selling MBS, it will need to buy treasuries.

The Fed can always decide to sell short term treasuries and buy long term treasuries if it wants to do another round of “Operation Twist.” Either way, the Fed will be buying treasuries for many years to come. It’s not as if that’s a huge deal anyway because treasury yields are historically low. It would matter more if yields were spiking because it would balloon the deficit.

Powell mentioned high deficits are bad, so the Fed won’t be buying treasuries to support an extreme fiscal measure which balloons the deficit such as the Green New Deal or universal healthcare. It’s still very uncertain what the Fed will do with the balance sheet in reaction to the next recession because this cycle was the first time it used its balance sheet as a monetary policy tool. The bears love to say QE 4 is coming this year, but that has a minuscule chance of occurring.