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Dr Tano Pelosi, Antares Fixed Income
What is quantitative easing? Quantitative easing is when central banks purchase assets from the market to lower interest rates and increase credit availability to help stimulate the economy.
Eight years after the inception of quantitative easing (QE), the US economic expansion is now one of the longest running in post-war history. Despite an economic backdrop of moderate investment, modest productivity, and low inflation and wage growth, the performance of investment markets has been impressive. The monetary accommodation policies pursued by central banks have resulted in increased liquidity in global capital markets. In the last 12 months alone central banks have added approximately US$1.5 trillion of stimulus packages.1
Against this backdrop global central banks are now preparing the groundwork for a reduction of accommodative monetary policy, commencing with the US Federal Reserve (Fed) in October 2017. If current economic conditions prevail the Fed will begin to unwind its US$4.5 trillion balance sheet, initially tapering maturity proceeds in the order of US$10 billion per month (US$6 billion per month for Treasury Notes and US$4 billion per month of mortgage-backed securities).2 The taper cap will then increase to US$50 billion per month in 12 months’ time.3
The impact on investment markets
Given its uncharted nature, there are no road maps to help navigate investment markets as we embark on unwinding of QE. However, we contend that the proposed actions of central banks to reduce liquidity in global capital markets could affect investment markets in at least three ways:
1. Higher volatility is likely
So far, markets appear relatively sanguine to the possibility of tightening financial conditions – yields for instance have barely risen and volatility measures remain at record historic lows. The sensitivity of markets to potential tightening however cannot be underestimated. Even nuanced gestures by central bankers towards interest rate normalisation have revealed how disproportionate a role central banks can play in investment markets. The ‘taper tantrum’ in 2013 and more recently the Bank of England and European Central Bank (ECB) guidance towards monetary normalisation have seen outsized market reactions. Market volatility could rise.
2. Financial conditions should tighten
In unwinding QE the amount of US government debt held by the public should increase, which in theory should tighten financial conditions, by pushing interest rates higher.Tightening financial conditions typically lead to higher borrowing costs, and likely result in less speculative activity in investment markets and ultimately helps keep leverage in check. Some tightening of monetary policy should therefore be welcome from a financial stability perspective, given rising imbalances in the economy, including rising asset price inflation, and negative interest rates. However, too much tightening of financial conditions would likely lead to negative wealth effects and less discretionary spending power for consumers, leaving the economy vulnerable to a downturn.
3. Pressure for bond yields to rise
The Fed’s own research suggests that the cumulative effect of the Fed’s QE policies accounts for approximately one full percentage point in the reduction in long-term maturity bond yields.4 On this basis alone, a rapid reversal of QE could see global bond yield curves steepen considerably, and longer-term bonds becoming more attractive.
Far from a rapid retrenchment though, we believe the Fed intends to run a very gradual withdrawal of QE. While this strategy should not alarm investors, the impact on bond returns may also be influenced by the ongoing US Department of Treasury’s net bond issuance (currently US$50 billion per month), and what other central banks, like the ECB, are likely to do with their own taper programs.5
We believe a well-telegraphed unwinding of central bank balance sheets removes, to some extent, the need for central banks to raise interest rates further than otherwise justified by inflation. While a pick-up in inflation would likely result in higher interest rates, the risk of the US economy overheating is relatively low at the moment with actual output of the economy roughly similar to its potential output.
It is plausible that other central banks may look to withdraw accommodation through 2018 whilst attempting to normalize interest rates at the same time. As this scenario is largely underpriced by markets it could result in increased market volatility if realized. As a result we think it’s more likely there will be a concerted effort for any QE withdrawal to be done in a measured and prudent way given the potential negative consequences. Importantly for all investors, this could allow the economic and investment cycles to become more synchronised and sustained over the longer term.
1. This figure includes the central banks of Sweden, US, UK, EU, and Japan. Source National Central Banks, Citibank Research Aug 2017, and Antares.
2. Transcript of Chair Yellen’s Press Conference, June 14, 2017.
3. Transcript of Chair Yellen’s Press Conference, June 14, 2017.
4. Brian Bonis, Jane Ihrig, Min Wei (2017) https://www.federalreserve.gov/econres/notes/fedsnotes/effect-of-the-federal-reserves-securities-holdingson-longer-term-interest-rates-20170420.htm
5. Antares estimate and Bloomberg.
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