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Global Fixed Income Strategy abc Special Global Research Our non-consensus view is that QE3 will drive US Treasury yields to new It’s not about the lows money The impact of the Fed’s trillions is passed onto assets in five ways, which we identify and use to create a QE Fed’s trillions are bullish for bonds Scorecard Our QE Scorecard implies that QE3 is bullish for Treasuries, credit, EM debt and equities, but bearish for mortgage and inflation-linked bonds The Fed’s QE trillions are not ‘printing’ money The Federal Reserve’s new wave of quantitative easing (QE3) follows similar large-scale asset purchase policies adopted in November 2008 (QE1) and November 2010 (QE2). Each step of the Fed’s unconventional policy response – which will soon add up to close to USD2 trillion – has been met with controversy. Opposition comes from those who think QE has no real economic impact, to those who believe the policy will be inflationary. But it’s not about the money, rather about where it goes and how it is used. 27 September 2012 We assess the impact of the Fed’s trillions by tracing where Steven Major, CFA the money went, and where the cash received by investors Strategist selling assets to the Fed was invested. By following the HSBC Bank plc money, we identify five ways Fed purchases are felt by +44 20 7991 5980 firstname.lastname@example.org markets and the wider economy: 1) yields on assets targeted Lawrence Dyer by the Fed; 2) use of cash by investors selling to the Fed; Strategist 3) bank reserves; 4) economic expectations; and 5) policy HSBC Securities (USA) Inc. expectations. There is no printing of money analogous to +1 212 525 0924 email@example.com 1920s Germany: the Fed is effectively funding its purchase of assets by steering reserves in the banking system in certain directions. We used these insights to create a QE Scorecard to assess the potential impact of QE3 on Treasuries, mortgage bonds, View HSBC Global Research at: http://www.research.hsbc.com inflation-linked debt, credit, EM debt and equities. Our conclusion is the opposite of the consensus view that QE3 Issuer of report: HSBC Bank plc will be inflationary and push US Treasury yields higher, and our target is for 10-year Treasury yields to test the 1.4% low Disclaimer & Disclosures point in the coming months. This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it Global Fixed Income Strategy Special abc 27 September 2012 Contents Where will the Fed’s billions Appendix 1 16 be felt the most? 3 Agency holdings 16 More QE from the Fed 3 QE Transmission Mechanism Scorecard 3 Appendix 2 18 Corporate holdings 18 Non-consensus view – lower US Treasury yields 4 US Treasuries 4 Appendix 3 20 Inflation-linked bonds 6 Treasury holdings 20 Mortgage bonds 6 Corporate bonds 7 Appendix 4 22 EM bonds 8 Disclosure appendix 25 Equities 8 Disclaimer 27 Where the money went in QE1 and QE2 10 Finding traces of QE 10 It’s not about the money 13 Reserves are created by the Fed 13 2 Global Fixed Income Strategy Special abc 27 September 2012 Where will the Fed’s billions be felt the most? US Treasuries will receive demand as direct substitutes to the mortgage market, which is already expensive The corporate bond market and EM bonds will also benefit from the need to replace assets the Fed buys There is an indirect spill-over effect into equities and commodities More QE from the Fed Such extrapolation is dangerous, not least because the market backdrop is different and the starting The Federal Reserve stepped up its efforts to point for valuations has moved significantly (see promote growth (13 September FOMC) in the Figures 2). However, it is important to understand persistently sluggish US economy, announcing how and where the Fed’s trillions have been felt another round of asset purchases and quantitative the most – and where the transmission easing – dubbed QE3. Based on USD40bn per mechanisms are the most direct – in order to month of new purchases of mortgage-backed understand better the way another round of asset securities, the policy will increase the amount the purchases could feed through to the wider markets Fed will have bought to USD2 trillion (assuming and economic expectations. one year of buying), making it one of the biggest investors in the world. QE Transmission Mechanism Scorecard In this report, we track the impact on the markets of the USD trillions of purchases so far. By 1 Yield levels of targeted bonds – the extent to following this trail, we aim to understand the which the Fed as an investor has influenced transmission mechanisms of QE and analyse how prices. these might evolve under the latest QE3. With this 2 The use of cash received by investors – those framework, it is possible to assess the potential who have sold assets to the Fed. impact of QE3 on assets, including US Treasuries, mortgages, inflation-linked bonds, corporate 3 Reserves created in the banking system – the bonds, equities and EM. extent to which the Fed’s QE has diverted banks’ capital from lending. Five transmission mechanisms of QE To estimate the impact of QE3, it is not enough to 4 Investor expectations (eg, inflation) – the simply look at previous rounds of asset buying extent to which QE has shifted expectations and assume the impact will be the same or similar. of growth and stimulus. 3 Global Fixed Income Strategy Special abc 27 September 2012 5 Speculation on the impact of the policy – the Our view is that Treasury yields are likely to fall extent to which QE has shifted expectations as a result of the Fed’s policy of buying mortgage of what the Fed will do next. bonds. A re-test of the lower end of the recent range for 10-year Treasury yields (1.40%) is There appears to be much more commentary likely as a result of QE3. about the last two and not enough analysis of the first three, in our opinion. The first three factors, When QE3 was announced 10-year yields temporarily broke out of the upper end of the 1.4- according to our analysis, are most important for 1.8% trading range (see Figure A14), which determining the price of Treasuries and mortgages, contributed to the consensus forecasts for higher whilst the latter could be better at explaining what’s yields. We do not share this consensus view, as this going on with other assets. presupposes that the recent move higher in yields is Non-consensus view – lower US purely to do with the Fed’s policy. Appendix 3 Treasury yields shows that investors’ Treasury positions can shift dramatically as they react to risks in other markets, The QE3 Scorecard incorporates five transmission as occurred around QE1. mechanisms and applies these to US Treasuries. US Treasuries Scorecard is bullish Figure 1. US 10yr Treasury yields lower because of QE 1. Neutral impact as not targeted 4.5 QE1 QE2 QE3 2. Bullish for Treasuries as cash from mortgage 4.0 10yr Treasury yield (%) bonds reinvested in UST 3.5 3.0 3. Bullish because it means further slowing of 2.5 bank loan expansion 2.0 4. Bullish for UST if low growth limits inflation 1.5 expectations 1.0 Aug 08 Jun 09 Apr 10 Feb 11 Dec 11 Sep 12 5. Neutral for US yields as low for longer persists Source: HSBC, Federal Reserve, Bloomberg Figure 2. All types of bonds have done well from QE, levels and spreads are close to historical lows 10 30 30 Mar 2008 31 Mar 2008 8 21 Sep 2012 25 21 Sep 2012 6 20 Yield (%) Yield (%) 4 15 2 10 0 5 US EUR 5yr 5yr BEs Credit EM -2 0 IG Local Mkts Mortgage 3mth CP AA A BBB BB B BB US EUR 5yr Tsy 30yr Tsy BTP Bund Bono GBP Note: US Mortgage rate uses consists of the 30 year FNMA current coupon as generated by MCCN. Credits buckets are comprised of all maturities. US Breakeven data goes only goes back to 10/12/2008. Source: HSBC, Bloomberg, Markit, Thomson Reuters Datastream 4 Global Fixed Income Strategy Special abc 27 September 2012 In fact the opposite might be true. US Treasury The main bullish points for Treasuries are: yields are still towards the bottom of the longer- The Fed is most unlikely to allow yields to rise term trading range and are lower than when QE significantly as a result of the policy, potentially started in 2008 (see Figure 1). A large proportion capping 10 year yields around 2.0%. of the upward move in yields that occurred since late July can be associated with the policy moves Treasuries are likely to be bought out of the of the ECB, including the announcement of OMT proceeds of mortgage bond sales and/or (outright market transactions), which has been prepayment flows. seen as a step on the path to a more durable The Fed’s policy of using reserves to fund solution to the eurozone crisis (see The ECB’s purchases means the composition of bank game changer, 21 August 2012). US Treasury balance sheets is changing so that there are a yields have been moving inversely to those of the lower proportion of loans than before. This eurozone periphery (see Figure 3), with the may become a constraint on US growth. decline in Spanish yields mirroring the upward shift in Treasuries, for example. Generating inflation expectations may have become a goal of policy, but it is already implied in negative real yields and higher Figure 3. Influence of the eurozone on US rates inflation break-evens. 2.5 7.6 Future policy is difficult to predict, but more 7.2 2.2 QE and the ‘low for longer’ Fed funds 6.8 10yr yield (%) 10yr yield (%) outlook is likely to result in support for 1.9 6.4 Treasuries and yield compression. 6.0 1.6 5.6 5.2 1.3 4.8 Oct 11 Dec 11 Mar 12 Jun 12 Sep 12 US (LHS) Spain (RHS) Source: HSBC, Bloomberg Table 1. QE Transmission Mechanism Scorecard 10yr Treasuries Mortgage bonds Inflation-linked & Corporates EM bonds Equities commodities Yield levels of n/a Spreads have already n/a n/a n/a n/a targeted bonds tightened significantly The use of the cash Bullish, attracts Bearish as substitutes Neutral Bullish Bullish Neutral received investment attractive Reserves created in Bullish, less balance Bearish as banks reduce Neutral Neutral Neutral Neutral banking system sheet for loans rich asset holdings Investor expectation Bullish if growth limits Bullish whilst Fed a large Break-evens have Modest bullish on Bullish Bullish (eg inflation) inflation buyer already risen equities Speculation on policy Bullish as 'low for Neutral, wait for economy Previous episodes saw Neutral Varied Bullish impact longer' QE-based rallies Source: HSBC 5 Global Fixed Income Strategy Special abc 27 September 2012 Inflation-linked bonds the ultra-long segment, providing a further incentive for investors to buy and hold the linkers. Scorecard is bearish One of the conundrums of the past few years has Past experience of QE would suggest higher BEs been the collapse in the velocity of money even could follow the QE, but valuations suggest this is while some measures of risk appetite and inflation not the same trade as in 2008-09. The assertion have been rising (see Figure 5). The Fed has often made is that the increase in the size of the expanded the reserves in the banking system, but central bank’s balance sheet will result in higher this has not resulted in a rise in the broader inflation and that this should be reflected in a rise in measures of money supply, reflecting the weak state inflation expectations. In fact US BEs (break-evens) of the economy and continued deleveraging. The have already risen since the announcement of QE3 current environment is a challenge to those who and are significantly higher than at the start of QE in believe increased money supply results in 2009, when sub-zero levels were implying higher inflation. deflation. The most recent increase in BEs (see Figure A16) shows that markets have been quick to Understanding that ‘it’s not about the money’ and price in additional inflation expectations and risk that with growth (and employment) so weak that premium. But if the Fed’s policies fail to show wages are unlikely to rise makes it possible to look tangible evidence of real GDP growth, then long through the recent rise in inflation expectations. TIPs positions would require real yields to go even more negative (see Figure 4) than they are. Figure 5. Velocity of money falling whilst risk assets rise 1600 2.2 Figure 4. US 10yr real yields have been negative for some time 1400 2.1 4 1200 2.0 1000 3 I ndex Ratio 800 1.9 Real swap rate (%) 2 600 1.8 1 400 1.7 200 0 0 1.6 -1 86 88 90 92 94 96 98 00 02 04 06 08 10 12 -2 EUR S&P 500 (LHS) CRB Rind (LHS) USD US M2 Vel oci ty (RHS) -3 Source: HSBC, Bloomberg Oct 07 Dec 08 Mar 10 Jun 11 Sep 12 Source: HSBC, Bloomberg Mortgage bonds Negative real yields have been observed before and Scorecard is bearish already exist across most of the developed market Mortgage bonds are expensive by historical yield curves, except for the ultra-long segments. standards and with the Fed’s actions likely to And it would be a logical outcome for the entire real spark new supply from refinancing over time, the yield curve to move lower from a scenario which main beneficiaries from the Fed’s actions will be involved the economy staying weak and the Fed’s other categories of fixed income. Initial purchases serving to contain nominal bond yields. conditions, the current coupon 30-year mortgage Asset-swaps on inflation-linked bonds are generally spread of 10bp over the 10-year Treasury higher than conventional equivalents, especially in (Figure A15), are quite different from those 6 Global Fixed Income Strategy Special abc 27 September 2012 before the Fed’s QE1 mortgage purchases, when already owns USD80bn of these coupons in its the spread was as much as 200bp, because of USD1trn mortgage portfolio). However, many active selling by foreign investors and households. more will be made as existing mortgages Spreads are way below their historical norms at are refinanced. present and the most likely scenario is that the Fed The Fed’s QE3 announcement caused the spread buying will contain yield spreads in the near term, of the current coupon 30-year mortgages to not drive them much lower. narrow from 80bp over the 10-year T.Note to In fact the risk is that today’s very rich levels may 10bp, as investors bought ahead of the Fed (see not be sustained if the pace of refinancing and Figure A14). Adjusted for the mortgages’ curve creation of new bonds, likely to run at USD1.2trn and convexity risk (option-adjusted spread), low- per year or more over time, moves too far ahead coupon mortgage yields are 20-30bp through the of the Fed’s pace of buying (currently set at Treasury curve, which should attract willing USD480bn per year). A second concern is that the sellers into ‘risk free’ Treasuries at these levels. real economy will only benefit if today’s low Furthermore, assuming the economy is still weak; market rates are passed on to borrowers. So far, the Fed itself may restart a traditional QE that has not been the case. programme to buy Treasuries if the yield was to rise. A cap could be 2.0% for 10 years. The Fed is likely to target low-coupon mortgages, created either from a new home purchase or Corporate bonds refinancing of an existing high-coupon mortgage. Scorecard is bullish Buying low coupons does the most to reduce new mortgage rates for consumers and thus to increase Understanding what current mortgage holders will consumption (as refinancing lowers mortgage buy is the key to understanding the outlook for US expenses) and increase home demand (as corporates. The largest holders of agency mortgage costs fall). mortgages and debt – banks, mutual funds and foreign investors – should see the largest Existing mortgages are held by banks, foreign prepayments. These are professional investors investors and mutual funds (as shown in with intermediate to long-term horizons. Appendix 1). As these mortgages are refinanced, Therefore, they are unlikely to find the current investors receive principal payments and must rich value of new production mortgages attractive decide how to invest them. These investors may and will be looking for substitutes in the credit compete with the Fed in buying the new, richly markets. Appendix 2 reviews the behaviour of priced, low-coupon mortgages or they may direct corporate bond investors as reviled by their the prepayment into another investment sector. investment flows. The vast majority of these principal payments should be redirected into fixed-income Mutual funds and pension managers are short- investments, but the question is which ones. term performance driven, as they are evaluated versus bond indices, so they should see value in The limited supply of low-coupon mortgages has corporate bonds, even after the recent spread contributed to their large spread tightening. There tightening, as well as Treasuries. Their are only USD47bn of 30-year 3% mortgages and performance benchmarks would continue to hold USD311bn of 30-year 3.5% mortgages currently mortgage securities, so there may be some available for the Fed to purchase today (the Fed demand for rich mortgages to limit tracking errors 7 Global Fixed Income Strategy Special abc 27 September 2012 while adding yields. Since the total size of the curve flattening driven by the building up of corporate bond market has been stable, this inflation expectations. incremental demand should be positive and help Pablo Goldberg (Strategist, (HSBC Securities USA)) keep spreads on a tightening trend. Equities Figure 6. Triple B corporate bond spread and QE Scorecard is bullish Corporate BBB spread to 10yr Treasury (%) 5.0 4.5 QE1 QE2 QE3 For equities, the most significant aspect of the 4.0 latest QE announcements is that they are open- 3.5 ended commitments. Neither the Fed nor the ECB 3.0 2.5 has announced a size or an end-point. This bodes 2.0 well for equities to judge from the previous 1.5 experience of QE. 1.0 Figure 7. QE boosts equities Jul 08 May 09 Mar 10 Jan 11 Nov 11 Sep 12 400 Source: HSBC, Federal Reserve, Bloomberg QE1 QE2 LTROs 350 World equi ty i ndex EM bonds 300 Scorecard is bullish 250 The effect of QE on emerging markets is both 200 direct and indirect, and has different implications Draghi by asset class and duration. Further stimulus in the 150 Feb 09 Nov 09 Aug 10 May 11 Feb 12 Sep 12 US tends to lead to ‘risk-on’ trades, which is generally beneficial for EM spreads, while it tends Source: HSBC, Bloomberg to lower (or cap) US yields at very low levels. Renewed search for yield follows, particularly by There have been essentially two episodes of QE: investors with guaranteed returns on liabilities Japan in 2001-04; and the US, Japan, the UK and that cannot be met by their ordinary investment the eurozone, to varying degrees, after the alternatives. Hard currency EM bonds are the first financial crisis of 2008. We draw the following to receive the beneficial impacts of QE. lessons from these episodes: In a second order, QE risk-on effects also boost EM 1 QE did on average have a positive impact on currencies, leading to gains in local currency bonds. stock markets (see Figure 7). Three months FX gains are the single most important driver of after the announcement of QE, stocks in the local currency performance and performance US rose by an average 6%, in the UK by 8% volatility (see Searching for Safety: A new source of and in the eurozone by 15%. demand for EM assets, 25 September). Yet QE tends 2 The US and UK saw a more consistent to translate into higher commodity prices and impact of QE on stocks than did Europe or inflation expectations, which pressure the front-end Japan. This may well be because the quantum of the local EM curves. While the initial impact of QE was bigger. tends to be bullish overall, there is a subsequent 8 Global Fixed Income Strategy Special abc 27 September 2012 3 The impact on equities can be negative when the central bank stops buying. The end-points of Fed QE in May 2009, June 2011 and the end of the ECB’s LTRO in March 2012 highlight the risks. 4 The impact of QE can be short-lived. In Japan, stocks had a brief bounce after the first announcement of QE in 2001, but fell for the following two years despite increases in the QE target. QE was also notably ineffective in Japan in 2010-11. The first round of QE after the global financial crisis in 2008 similarly triggered a short-term bounce, but stocks then fell until the second (bigger) QE, announced for example by the US in March 2009. We stress that liquidity is only one side of the coin for equities. Signs of a rebound in economic growth would greatly increase our confidence that any rally in equities could be sustained. However, we believe it is dangerous to be too negative on equities when the world’s major central banks are prepared to inject liquidity without specific limits on size or duration. Garry Evans (Equity Strategist, (HSBC Bank plc)) 9 Global Fixed Income Strategy Special abc 27 September 2012 Where the money went in QE1 and QE2 The Fed asset purchases grab the headlines, but starting points and knock-on effects are important to post-QE performance We use our QE Scorecard to show the transmission mechanisms in combination with market conditions are key to market performance Today's initial conditions -- rich mortgage spreads -- and the behaviour of large investors suggests significant rotation from mortgage holdings into Treasuries in QE3 Finding traces of QE analysis also shows who currently owns large mortgage positions and discusses how these owners Commentators and many investors speak of the are likely to choose between competing with the Fed Fed’s QE as “printing money”, implying that funds to buy mortgages or rotating mortgage positions in just get thrown into the financial system. But as to the Treasury or corporate band markets USD 1.5trn of excess reserves move through the economy they leave traces that can be tracked Our views on the likely performance of markets through official data. depend upon the QE scorecard and initial conditions in the markets. In QE1, the extremely Excess reserves grew to represent roughly 10% of stressed spread levels for mortgages and corporate GDP and 10% of bank assets. The Flow of Funds bonds meant that spreads had room to tighten report allows us to follow the money created in QE1 and QE2 and helps guide how QE3 will affect the Figure 8. QE and the impact on MBS and Corporates markets and the economy. 5.0 Appendices 1 to 3 tract the Flow of Funds report QE1 QE1 Spread over 10yr Tsy (%) 4.0 expansion from the Federal Reserves to show the evolution of 10yr Corp BBB investors’ holdings of mortgage, corporate, and 3.0 30yr MBS Treasury bonds, respectively, through the financial 2.0 crisis. Investment risk in the mortgage and corporate market was redistributed from foreign and selected 1.0 domestic investors to the Federal reserve and other 0.0 domestic investors. Mutual funds and banks added Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 to their agency security holdings, for example. This Source: HSBC, Federal Reserve, Bloomberg 10 Global Fixed Income Strategy Special abc 27 September 2012 significantly. Figure 8 shows the wide spreads to showing limited signs of stress. However, the 10- Treasuries for the current coupon 30-year year Treasury’s yield had fallen on fears of slower mortgage and 10-year Triple-B industrial bond economic growth. In this case, the Fed initiated a sectors around QE1. Other investors joined the USD600bn Treasury buying programme. Fed’s buying cheap spread assets in this case, as Spread continued to trade within its recent range. shown in the appendices. However, QE2 led to a significant shift up in Treasury yields (see Figure 10) and TIPS break- Figure 9. QE2 was about Treasury purchases… even spreads. In this case, we believe shifts in the 2.0 forward looking factors on the QE scorecard QE2 contributed to the behaviour of spreads. Spread over 10yr Tsy (%) 1.5 Figure 10. …..but the market didn’t benefit immediately after 1.0 4.5 QE2 10yr Tresury yield (%) 0.5 4.0 10yr Corp BBB 30yr MBS 3.5 0.0 Jan 10 Apr 10 Aug 10 Nov 10 Mar 11 Jul 11 3.0 Source HSBC, Federal Reserve, Bloomberg 2.5 Table 2 shows our view of how the QE Scorecard 2.0 would have looked before QE1. The appendices Jan 10 Apr 10 Aug 10 Nov 10 Mar 11 Jul 11 show the flows between investors and today’s Source: HSBC, Federal Reserve, Bloomberg initial that help determined our views. The importance of initial conditions in determining market performances in QE1 and QE2 highlights the using past performance to predict future investment results is potentially hazardous. Initial conditions had changed around QE2. Figure 9 shows that mortgage and corporate spreads were Table 2. QE1 Transmission Mechanism Scorecard 10yr Treasuries Mortgage bonds Inflation-linked & Corporates EM bonds Equities commodities Yield levels of Bullish as targeted in Bullish targeted asset n/a n/a n/a n/a targeted bonds second round The use of the cash Bullish as MBS sellers Neutral Neutral Bullish Bullish Neutral received bought Tsy Reserves created in Neutral given low base Neutral Neutral Neutral Neutral Neutral banking system Investor expectation Bearish as QE Bullish on Fed demand Break-evens Bullish given initial Bullish Bullish (eg, inflation) expected to work and initial conditions increase as deflation conditions avoided Speculation on policy Initially bullish on Fed Bullish given “all in” Fed Expect higher Bullish given all in Bullish Bullish, but impact duration buying, then commitment inflation Fed commitment financial bearish on expected crisis success of QE dominated Source: HSBC 11 Global Fixed Income Strategy Special abc 27 September 2012 Table 3. QE2 Transmission Mechanism Scorecard 10yr Treasuries Mortgage bonds Inflation-linked & Corporates EM bonds Equities commodities Yield levels of Fed buying n/a n/a n/a n/a n/a targeted bonds reflected in low yields The use of the cash Bullish as sellers Neutral Neutral Bullish Bullish Neutral received bought more Tsy Reserves created in Neutral given Neutral Neutral Neutral Neutral Neutral banking system moderate base Investor expectation Bearish as QE Neutral given initial Bullish for Break-even Modestly bullish Varied Bullish (eg inflation) expected to work conditions and commodities given initial given initial conditions conditions Speculation on policy Bearish as QE Neutral given initial Bullish Neutral Varied Bullish impact expected to work conditions Source: HSBC 12 Global Fixed Income Strategy Special abc 27 September 2012 It’s not about the money The Fed’s QE buying simultaneously increased its reserves (a liability) and the banking system’s reserves (an asset) – which are balance sheet events QE shifts assets among investors; it does not in create money magically as some commentators seem to believe If anything the Fed’s actions eventually risk crowding out traditional bank lending and act as a break on economic activity as the cost of funding for banks is higher than the interest received on the reserves Reserves are created by the Fed Figure 11. Bank reserves jump on Fed asset buying 1800 The Fed’s QE creates reserves in the banking 1600 system, which is the funding source for the Fed’s Total bank reserves (USDbn) 1400 asset purchases. Excess reserves in the banking 1200 system now stand at USD1.5trn (see Figure 11), 1000 800 representing 10% of total assets, a relatively new 600 development (in 2007 pre crisis this was 0.2%). 400 200 There seems to be a poor understanding that the 0 reserves created in QE are an asset in the banking Dec 06 Jun 08 Nov 09 Apr 11 Sep 12 system and a liability for the Federal Reserve. Source: HSBC, Federal Reserve Some analysts assume that the reserves “create” new deposits in the banking system, and so do not Don’t say printing, this is balance sheet affect bank decisions. However, unless the There has been no ‘helicopter drop’ and there is ultimate sellers of assets to the Fed, such as certainly no printing of money. Analogies foreign investors or mutual funds, choose to hold between current US monetary policy and 1920s low yielding bank deposits instead of reinvesting Germany miss the point: Printing money is fiscal in a more substitute asset, this cannot be the case. policy and not an option for the Fed or any other The conventional view assuming the new reserves modern central bank. The Fed is buying bonds in create a new deposit does not have empirical or the secondary market. In contrast, during the theoretical support, based on balance sheet effects German hyper-inflation, government tax revenue and as demonstrated in the Flow of Funds report. was as low as 1% of government spending – the 13 Global Fixed Income Strategy Special abc 27 September 2012 rest of the spending was done by printing money QE is unlikely to significantly increase net with no intent to collect the taxes needed to pay lending. It may reduce borrowing costs but this for it. This would imply the Fed’s liabilities effect is likely to be dwarfed by the financial increase (currency in circulation) but its assets do headwinds -- the large debt burden in the US and not. The USD1.5trn of excess reserves leaves economic crisis in Europe. On the other hand, if traces in the form of assets and liabilities. there were an increase in savings to fund the Analysis of the Flow of Funds shows the investors reserves, then consumption must fall to fund the who sold assets to the Fed in QE1 were primarily savings, or growth must pick up to create wealth foreign holders of spread product who reinvested (unlikely). Banks are not complaining about their their cash generated by sales into the Treasury deposits at the Fed today. However, knock on market. In QE2 the Fed and foreigners bought the effects likely limit QE’s economic effectiveness increased Treasury issuance while other investors and this analysis points out that there is a point shifted spread asset holdings. The Fed’s where the costs of QE to banks should outweigh borrowing shows up as loans on the banks’ its benefits for the Fed. This supports a low for balance sheets while the currency in circulation longer rate view. grew on its trend line. Who loses? Excess reserves crowd out loans by banks The more QE and the longer the Fed continues it, Through the quantitative easing, the increased the larger the Fed’s share of the banking system’s reserves have been reflected in a change in the balance sheet. Figure 12 simulates the reserves composition of bank balance sheets (more share of the banking system’s balance sheet reserves, fewer loans) not the total size. Indeed assuming USD40bn and USD80bn QE the limited growth in bank balance sheets is programmes and no increase in bank deposits. because of shrinkage (deleverage) in other areas, Excess reserves were negligible in 2007; now they most likely shadow banking. are the fourth-largest asset class in the banking system. Twelve months of the mortgage QE3 The average cost of fund to banks is significantly would make reserves larger than the banks’ higher than the interest received on the reserves current third-largest position – their USD 1.9bn of from the Fed; according to the Federal Reserve agency mortgages. That seems manageable for the Bank of San Francisco the average cost of funds banking system. Twenty-four months of a was 1.06% in July. USD80bn QE would make reserves the second- Catch 22 for QE largest asset class in the banking system – just By crowding out other types of assets on the behind the banks’ current USD4.4trn non-agency balance sheet, assuming that there has been no mortgage position. That size risks harm. Banks increase in savings, the reserve growth is would have to sell or mature USD480bn to hampering economic activity. Banks may be less USD2trn of assets, respectively, for these able to lend to small businesses and others and the scenarios. The question is which assets? Fed’s actions may not help the real economy in the end. 14 Global Fixed Income Strategy Special abc 27 September 2012 What the Fed said on 13 September Figure 12. Reserves take over more bank balance sheet for QE The September FOMC statement committed the Fed Reserves as a percent of total bank assets 30% USD80bn/mo QE to buy USD40bn of agency mortgages each month 25% USD40bn/mo QE in its third quantitative easing programme. The 20% statement links the programme’s length and potential 15% for additional QE, to the state of the labour market: 10% “If the outlook for the labour market does not 5% improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, 0% Dec 06 Dec 08 Dec 10 Dec 12 Dec 14 undertake additional asset purchases, and employ its other policy tools as appropriate until such Source: HSBC, Federal Reserve improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficiency and costs of such purchases.” 15 Global Fixed Income Strategy Special abc 27 September 2012 Appendix 1 Agency holdings Foreigners have been sellers Foreign investors were large buyers of agency securities up to 2008 (see Figure A2). They became Total agency debt and mortgages outstanding have sellers in the debt crisis, contributing to market stresses. stabilised at USD7trn (see Figure A1). The limited Households and businesses initially bought agencies, growth in agencies since the start of the crisis means the but have since liquidated their holdings. The ABS and Fed’s mortgage purchases will displace current holders. REIT holders sold initially, but have since been buyers. This section of the Flow of Funds report combines agency mortgages and debt. Since investors typically treat the two as close substitutes this does not affect Figure A2. Sectors selling since end-2008 our conclusions. 2000 Agency holdings (USDbn) Figure A1. Total agency mortgages and debt 1500 7500 Total agency holdings (USDbn) 1000 7000 6500 500 6000 0 5500 02 03 04 05 06 07 08 09 10 11 12 5000 Foreign Household & business ABS/REITs 4500 Source: HSBC, Federal Reserve 4000 02 03 04 05 06 07 08 09 10 11 12 The wide spreads caused by uncertainty and selling Source: HSBC, Federal Reserve initially saw buying by mutual funds. Later the Fed started QE1 (see Figure A3). Since mid-2009 banks Fannie Mae, Freddie Mac and Ginnie Mae fixed- have been consistently increasing their mortgage coupon mortgages targeted by the Fed total roughly exposure. This was an offset to reducing higher risk- USD4trn. Various floating-rate agency mortgages total weighted corporate debt (see next section). The Fed’s over USD1trn. These agencies’ debt plus the Federal holdings fell as it received principal payments until it Home Loan Bank’s make up the majority of the initiated its mortgage reinvestment programme in 2012. remaining USD2.2trn in debt. 16 Global Fixed Income Strategy Special abc 27 September 2012 Figure A4 shows the current agency holdings for a Figure A3. Sectors buying since end-2008 range of investors and their positions in April 2008. 2500 Agency holdings (USDbn) In QE3 the Fed will buy low-coupon issues, so most of 2000 the holders will either have to compete with the Fed to 1500 buy richly priced mortgages or shift into other assets. 1000 The investors most affected will be banks, mutual funds 500 and foreign investors. The next section examines their 0 behaviour to determine their likely reinvestment 02 03 04 05 06 07 08 09 10 11 12 choices. Fed Banks Mutual funds Source: HSBC, Federal Reserve Figure A4. The Fed will have to buy bonds from the current large domestic holders; banks and funds Total agency holdings 2008 (USDbn) 2500 30 June 2012 2000 31 March 2008 1500 1000 500 0 State & local Mutual funds Dealer/Finance Insurance Household & ABS/REITs Pension Fed Banks Foreign business Source: HSBC, Federal Reserve 17 Global Fixed Income Strategy Special abc 27 September 2012 Appendix 2 Corporate holdings Mutual funds have been buying Figure A6. Foreign holders and banks have been main sellers corporates through the crisis Holdings of corporate securities (USDbn) 3000 The total amount of corporate debt outstanding has 2500 stabilised at USD12trn (see Figure A5). This includes 2000 long- and short-term investment-grade and high-yield 1500 debt. It also includes foreign debt issued in USD or that 1000 held by US residents. The total amount of corporate 500 debt initially fell during the debt crisis, likely owing to 0 a drop in commercial paper outstanding. 02 03 04 05 06 07 08 09 10 11 12 Foreign Banks Finance Household Figure A5. Total corporate holdings Source: HSBC, Federal Reserve Total holdings of corp securities (USDbn) 13000 12000 Mutual funds, pensions and insurance companies have 11000 10000 been the biggest buyers of corporate debt since the debt 9000 crisis started and have tended to add exposure recently 8000 (see Figure A7). They are the investors most likely to 7000 rotate out of mortgages and into a mix of corporates and 6000 Treasuries because of QE3. 5000 02 03 04 05 06 07 08 09 10 11 12 Figure A8 shows the total corporate bond holdings Source: HSBC, Federal Reserve across the different investor sectors. The household sector has a significant corporate holding, but only Foreign investors were significant buyers of corporate small holdings in agencies (see Figure A4). This means bonds up to 2008, but they became large sellers, Figure it has no agencies to roll out of. The remaining sectors A6. Banks began to pare holdings around the same time have had stable or falling exposure to corporates and have continued to do so, likely because of the shifts recently and so seem less likely to add to corporate in the regulatory environment. The household and positions because of QE3. This set of investors, which finance sectors were initially buyers of corporate bonds includes foreign holders, seems most likely to roll from during the debt crisis but have tended to reduce any mortgage exposure into Treasuries. positions since mid-2009. 18 Global Fixed Income Strategy Special abc 27 September 2012 Figure A7. Pensions and Mutual funds have been main buyers Holdings of corporate securities (USDbn) 3000 2500 2000 1500 1000 500 0 02 03 04 05 06 07 08 09 10 11 12 Pensions Insurance Mutual funds Source: HSBC, Federal Reserve Figure A8. Distribution of corporate bond holders – expect most to add as mortgage holdings fall Total corporate holdings (USDbn) 3000 30 June 2012 2500 31 March 2008 2000 1500 1000 500 0 Mutual funds Household Insurance Finance Banks Pensions Governments Foreign Source: HSBC, Federal Reserve 19 Global Fixed Income Strategy Special abc 27 September 2012 Appendix 3 Treasury holdings All sectors have been buying Other Treasury investors’ positions shifted dynamically Treasuries as the market grew as the debt crisis unfolded. The Fed initially sold large amounts of Treasuries to make room on its balance Figure A9 shows the rapid increase in Treasury debt, sheet for its emergency lending programmes (Figure USD5.6trn, after the start of the financial crisis. Thus A11). Its holdings then jumped owing to the USD900bn most investor sectors have increased their Treasury of Treasuries purchases in QE1 and QE2, and the holdings reflecting the increased supply. additional mortgage principal reinvestments Figure A9. Total treasury holdings into Treasuries. 12000 Total Treasury holdings (USDbn) The mutual fund sector bought Treasuries in 2008 as it 11000 10000 reduced spread risk on performance concerns. The 9000 household sector, which includes hedge funds, has 8000 actively shifted from buyer to seller since, but was a 7000 6000 significant buyer around 2010. Its shifts reflect both its 5000 view of other asset classes and the value of Treasuries. 4000 3000 Figure A10. Foreign Treasury holdings 02 03 04 05 06 07 08 09 10 11 12 Total foreign Treasury holdings (USDbn) 6000 Source: HSBC, Federal Reserve 5000 4000 Foreign holdings in Treasuries dwarf the other investor sectors, so they are presented separately in Figure A10. 3000 Part of the jump in their Treasury holdings early in the 2000 financial crisis reflects their rotation out of spread 1000 product and into Treasuries, discussed above. 0 02 03 04 05 06 07 08 09 10 11 12 Source: HSBC, Federal Reserve 20 Global Fixed Income Strategy Special abc 27 September 2012 Figure A11. Other large holders dynamically shifted positions Figure A12. Surprisingly, banks have been buyers 1800 350 Fed Total Treasury holdings (USDbn) Total Treasury holdings (USDbn) 1600 Insurance Household 300 Banks 1400 Mutual funds 250 1200 1000 200 800 150 600 100 400 50 200 0 0 02 03 04 05 06 07 08 09 10 11 12 02 03 04 05 06 07 08 09 10 11 12 Source: HSBC, Federal Reserve Source: HSBC, Federal Reserve Figure A12 shows the banking sector has been a buyer of Treasuries since the start of the financial crisis. The commonly told story that banks sell Treasuries to the Fed is not supported by the facts on their balance sheets. Also, note that banks have modest Treasury holdings given the nearly USD15trn size of their balance sheets. The insurance industry initially sold Treasuries in the crisis to buy spread assets but has since added Treasuries. Figure A13 shows how the Treasury holdings for a range of investor sectors changed since the start of the financial crisis. Figure A13. Position changes since 2008 Total Treasury holdings (USDbn) 6000 5000 30 June 2012 4000 31 March 2008 3000 2000 1000 0 Insurance Mutual Fed Pensions Misc Banks Business Government funds Household Foreign Source: HSBC, Federal Reserve 21 Global Fixed Income Strategy Special abc 27 September 2012 Appendix 4 Figure A14. 10-year T.Note in low for longer range Figure A15. Current coupon mortgage spread richens to 10-year 30yr MBS curr cpn spread to 10yr Tsy (bp) 2.4 140 2.3 120 2.2 2.1 100 2.0 Yield (%) 1.9 80 1.8 60 1.7 1.6 40 1.5 20 1.4 1.3 0 Mar 12 May 12 Jul 12 Sep 12 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Source: HSBC, Bloomberg Source: HSBC, Bloomberg Figure A16. Inflation expectations already back towards top end Figure A17. Homebuyer mortgage rates lag falling market rates 4. 0 4.5 3. 5 4.0 I nflati on swap rate (%) 3. 0 Mortgage rate (%) 3.5 2. 5 2. 0 3.0 1. 5 2.5 1. 0 EUR 2s2s USD 2s2s 2.0 Primary MBS 0. 5 EUR 5s5s Secondary MBS USD 5s5s 1.5 0. 0 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Feb 07 Mar 08 May 09 Jun 10 Jul 11 Sep 12 Source: HSBC, Bloomberg Source: HSBC, Bloomberg Figure A18. Foreign investors shift into Treasuries 10000 Foreign holdings (USDbn) 8000 6000 4000 2000 0 02 03 04 05 06 07 08 09 10 11 12 Agency Corporate Treasury Source: HSBC, Bloomberg, Federal reserve 22 Global Fixed Income Strategy Special abc 27 September 2012 Notes 23 Global Fixed Income Strategy Special abc 27 September 2012 Notes 24 Global Fixed Income Strategy Special abc 27 September 2012 Disclosure appendix Analyst Certification Each analyst whose name appears as author of an individual chapter or individual chapters of this report certifies that the views about the subject security(ies) or issuer(s) or any other views or forecasts expressed in the chapter(s) of which (s)he is author accurately reflect his/her personal views and that no part of his/her compensation was, is or will be directly or indirectly related to the specific recommendation(s) or view(s) contained therein: Steven Major, Lawrence Dyer, Garry Evans and Pablo Goldberg Important disclosures Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations. Given these differences, HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon; and 2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative, technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating. HSBC has assigned ratings for its long-term investment opportunities as described below. This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this website. HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research report. In addition, because research reports contain more complete information concerning the analysts' views, investors should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not be used or relied on in isolation as investment advice. Rating definitions for long-term investment opportunities Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis: For each stock we set a required rate of return calculated from the cost of equity for that stock’s domestic or, as appropriate, regional market established by our strategy team. The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. For a stock to be classified as Overweight, the potential return, which equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated, must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*). 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Notwithstanding this, and although ratings are subject to ongoing management review, expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change. 25 Global Fixed Income Strategy Special abc 27 September 2012 *A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However, stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating, however, volatility has to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change. Rating distribution for long-term investment opportunities As of 27 September 2012, the distribution of all ratings published is as follows: Overweight (Buy) 48% (27% of these provided with Investment Banking Services) Neutral (Hold) 38% (26% of these provided with Investment Banking Services) Underweight (Sell) 14% (22% of these provided with Investment Banking Services) Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research. * HSBC Legal Entities are listed in the Disclaimer below. 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MICA (P) 038/04/2012, MICA (P) 063/04/2012 and MICA (P) 206/01/2012  27 abc Global Fixed Income Research Team Steven Major, CFA Global Head of Fixed Income Research +44 20 7991 5980 firstname.lastname@example.org Rates Credit Europe Europe Bert Lourenco Lior Jassur Head of Rates Research, Europe Head of Credit Research, Europe +44 20 7991 1352 email@example.com +44 20 7991 5632 firstname.lastname@example.org Subhrajit Banerjee Dominic Kini +44 20 7991 6851 email@example.com +44 20 7991 5599 firstname.lastname@example.org Theologis Chapsalis Laura Maedler +44 20 7992 3706 email@example.com +44 20 7991 1402 firstname.lastname@example.org Wilson Chin, CFA Remus Negoita, CFA +44 20 7991 5983 email@example.com +44 20 7991 5975 firstname.lastname@example.org Di Luo Anna Schena +44 20 7991 6753 email@example.com +44 20 7991 5919 firstname.lastname@example.org Chris Attfield Peng Sun, CFA +44 20 7991 2133 email@example.com +44 20 7991 5427 firstname.lastname@example.org Johannes Rudolph Pavel Simacek, CFA +49 211 910 2157 email@example.com +44 20 7992 3714 firstname.lastname@example.org Sebastian von Koss Raffaele Semonella +49 211 910 3391 email@example.com +44 20 7991 3153 firstname.lastname@example.org Asia Jayadev Mishra André de Silva, CFA +971-4-4235509 email@example.com Head of Rates Research, Asia-Pacific Asia +852 2822 2217 firstname.lastname@example.org Dilip Shahani Pin-ru Tan Head of Global Research, Asia-Pacific +852 2822 4665 email@example.com +852 2822 4520 firstname.lastname@example.org Grace Qiu Zhiming Zhang +852 2822 6569 email@example.com +852 2822 4523 firstname.lastname@example.org Himanshu Malik Devendran Mahendran Associate +852 2822 4521 email@example.com +852 3941 7006 firstname.lastname@example.org Philip Wickham Americas +65 6658 0618 email@example.com Larry Dyer Keith Chan +1 212 525 0924 firstname.lastname@example.org +852 2822 4522 email@example.com Jae Yang Louisa Lam +1 212 525 0861 firstname.lastname@example.org +852 2822 4527 email@example.com Pablo Goldberg Yi Hu Head of Global Emerging Markets Research +852 2996 6539 firstname.lastname@example.org +1 212 525 8729 email@example.com Crystal Zhao Bertrand Delgado +852 2996 6514 firstname.lastname@example.org EM Strategist +1 212 525 0745 email@example.com Linus Fung +852 2822 4687 firstname.lastname@example.org Gordian Kemen +1 212 525 2593 email@example.com Alex Zhang +852 2822 3232 firstname.lastname@example.org Victor Fu +1 212 525 4219 email@example.com Americas Van Hesser Alejandro Mártinez-Cruz Head of Credit Research, US Financial Institutions +52 55 5721 2380 firstname.lastname@example.org +1 212 525 3114 email@example.com Robert J Schmieder Head of Latam Corporate Credit +1 212 525 4829 firstname.lastname@example.org Mary Ellen Olson +1 212 525 0191 email@example.com Sarah R Leshner +1 212 525 3231 firstname.lastname@example.org Arjun Bowry +1 212 525 3119 email@example.com
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