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The long unwinding road of quantitative easing

According to Mark Burgess, CIO EMEA and Global Head of Equities, Columbia Threadneedle Investments, an unwinding of QE could cause increased volatility in the markets and a fight for remaining liquidity, as the supply of government bonds starts to disappear.

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  • Quantitative easing (QE) has resulted in heavily indebted developed economies and has had varying degrees of success.
  • An unwinding of QE could cause increased volatility in the markets and a fight for remaining liquidity, as the supply of government bonds starts to disappear.
  • QE has served its purpose of being a life raft for many of the largest economies and now central banks must start to go back towards the norm of pre-crisis levels, so that they have ammunition to tackle the inevitable next crisis.

The reasons for using QE and its effectiveness have been argued at length and this article aims not to discuss whether or not QE has worked, but to look at the likely next steps of central banks and how these could impact markets.

QE first reared its head in Japan in 2001, when the Bank of Japan (BoJ) became the first central bank to purchase government bonds financed by the creation of central bank reserves. This happened when the BoJ found itself backed into a corner as it approached the presupposed lower bound for nominal interest rates and needed to stimulate the economy. Following the global financial crisis, central banks in the US, UK and Europe were forced to follow suit, pumping large amounts of money into the banking system to prevent it from collapsing.

These measures have caused an array of consequences (intended or otherwise) that will need to be addressed sooner or later. At its core, QE has resulted in heavily indebted developed economies and has had varying degrees of success, which has arguably been dependent on the extent of distortions or frictions in the functioning of various markets.[1]

FIGURE 1: CENTRAL BANK BALANCE SHEET SIZE RELATIVE TO NOMINAL GDP (LHS) AND GOVERNMENT DEBT (RHS) Now that we are a decade on since the start of the crisis, surely it is time to think about what happens next to QE. Despite a fairly uniform decision to undertake QE across developed markets, the methods used have differed and so will the approaches to unwinding in the US, UK, Europe and Japan. The general market effects of QE have been lower discount rates, a weaker currency, and a strong environment for risk assets. Bank of England (BoE) studies have also shown there to be strong positive international spill-over effects of QE. Therefore, it is safe to assume that any rollback of QE would also have international impacts in such an interconnected world.

Are central banks maintaining their independence?

Before we get into the when and how, let us first consider if QE even needs to be unwound. Arguably, if the debts held by central banks are continually rolled over and the coupons on the debt are not required to be paid, then does the debt really exist?

The idea of simply cancelling QE debt has been bandied around and, although not economically different from central banks holding onto the bonds and accumulating cash flows indefinitely, markets would react very differently to these options. The budgetary implications of QE in the UK already correspond to a de facto debt cancellation, but a de jure cancellation would impede the BoE’s ability to resterilise the monetary base at some point in the future. This is something the former governor of the BoE, Sir Mervyn King, has highlighted but the BoE in particular wanted to avoid, as by doing this it would suggest that central bank independence is not so independent after all. Announcing debt cancellation would indicate that governments could indebt themselves without real consequences and could lead to consistent overspending. As markets lose their faith in the reliability of a country’s intentions to fulfil debt obligations, we could see inflation shoot up and the value of the country’s currency plummet. As we all know, trust is fundamental to the efficient functioning of markets – so which (if any) central bank is brave enough to admit to taking this step?

Consequently, could the rolling back of QE be considered so much of an inconvenience that central banks simply opt to keep it indefinitely on the balance sheets? This would certainly make those central bankers, already concerned by the bloated balance sheets, uneasy as they face the prospect of a new norm plagued by the threat of inflation and a lesser set of tools at their disposal in the event of the next crisis. Or perhaps there will be an attempt to gradually reduce the debt while trying to avoid another taper tantrum? Let us consider the likely options central banks could take around the world.

US

In the US, the Federal Reserve is arguably the furthest along in terms of starting down the path to the old status quo. The last of QE was completed in 2014, leaving the Fed with a portfolio of US$4.5 trillion on its balance sheet, which it has since maintained at this level by rolling over the debt and reinvesting any principal. While the Fed considers its stance on when the balance sheet can start to be reduced we have seen small rate hikes. The ‘softly softly’ approach is very much being taken with lots of hints being passed to the markets so as not to spook them and cause an event like the taper tantrum in 2013, which led to a surge in US Treasury yields. That event is precisely the reason that Federal Reserve Chair Janet Yellen is delaying an unwind, as the central bank wants to maintain a buffer to absorb economic shocks while the economy remains seemingly fragile.

As the Fed continues its gradual rate hiking we are likely to start to see a tapering of balance sheet reinvestment starting in 2018, with details emerging over the forthcoming Federal Open Market Committee (FOMC) meetings. With the current shape of the portfolio on the Fed’s balance sheet, if all the debt maturing is allowed to roll off then there would be a sharp run off in 2018, reducing until 2024 when this flattens out. To avoid such a large shock to markets, the path of the debt roll-off is much more likely to be smoothed as is indicated in Figure 2. In this scenario, we would expect to see a small amount of upward pressure at the long end of the curve of between 15-30bps towards the end of 2018. The tapered approach to debt roll-off would help the Fed maintain some flexibility to change its mind as the markets’ reaction is observed.

FIGURE 2: FED’S TREASURY PORTFOLIO For now we should expect further gradual rate hikes, which may pause if the FOMC starts to normalise the balance sheet later this year on the back of more positive economic numbers (as hinted by Dudley in a recent speech). Markets are yet to take Dudley’s suggestion or any more drastic options seriously, though surely at some point this will have to change – if the US does not set the trend of rolling back QE, what hope is there for the rest of the world?

UK

The next obvious place to follow suit in the unwinding of QE would have been the UK; however, studies have shown that any unwind is currently near impossible. This is because of the large amount of QE banks have used to meet their prescribed regulatory buffers. Any removal of this money will leave financial institutions fighting over remaining liquidity to avoid falling foul of these regulations. The way around this is to reduce the amount required to be held in buffers, but it is unlikely that central banks will want to take away that safety net.

It is important to note that in the UK we can see some of the unintended consequences of QE, which highlight the need to address the situation before more irrevocable damage ensues. Firstly the housing market has been impacted by artificially low rates inflating house prices as those with the means to put down large deposits invest. Banks insist on larger deposits as a means of identifying individuals who will be able to continue to service mortgages if interest rates increase, which keeps the younger generations off the housing ladder for longer. This is compounded by the fact that rent is going up, hindering those same younger generations from ever being able to save for a deposit.

At the other end of the generational scale, there are those whose defined pensions are at risk. The present value of long-term future-defined benefit pension liabilities has risen to the point that they are mismatched with the pension assets that have been boosted less by the lower rates and higher asset prices. These issues are starting to wear thin with the British public, so surely something must be done. Perhaps though, this is not yet the time for the BoE to make its move with the uncertainty of Brexit on the horizon. Interest rates will most likely stay low (though small hikes could be possible) to attract Foreign Direct Investment, which is so vital to the UK to finance its current account deficit. This does leave the country at risk of having minimal tools to use if another crisis were to take place. Maybe helicopter money or debt write-off are the next steps? In the UK, the equivalent of around 30% of overall debt has, from a budgetary perspective, already been effectively cancelled. So could it be argued that this might not be too much of a leap for the BoE?

Europe

2017 is all about politics in Europe with the numerous elections taking place. Markets have been suspicious after the shock votes in 2016, but so far fears have been unfounded as the populism craze seems to be going out of fashion. Also, in spite of the election concerns, we are seeing good economic numbers coming out of Europe which could suggest that more QE is less likely. Earlier this year Draghi stated that policymakers were now confident that they had removed the threat of a severe bout of deflation. Couple this with a calmer political outlook and we are likely to see the ECB move towards a less loose monetary stance.

The first stage for Europe has been the signal of the end of QE-infinity before an actual halt to QE − and then finally a roll-back much further down the line. So far, the ECB is around 80% of the way through the EUR2.28 trillion QE extension which will be complete by the end of the year, with a complete end of QE (with the potential to start tapering) as soon as the end of 2018, as the ECB is quickly running out of eligible bonds to buy. The ECB is the central bank most at risk, as it owns a large proportion of government debt of the multiple member states. This puts the ECB balance sheet at risk of default if there is a fracturing of the European Union.

FIGURE 3: ECB QE PURCHASES BY TYPE AND COUNTRY The ECB has stated that it will be tapering first and then considering rate hikes, so we are unlikely to see any hikes until the end of 2018 at the earliest. Draghi has gone further by outlining four necessary conditions for inflation to meet the price stability target before tapering can be considered. Inflation must be medium-term, durable (not just driven by base effects), self-sustained (not reliant on the extraordinary monetary conditions) and broad-based across the eurozone. It may be some time before this comes to pass and, even if interest rates start moving at the end of next year, the balance sheet still won’t shrink until 2020 or 2021.

What about Japan?

Japan was the first to use QE and the most likely to keep meaningfully extending its balance sheet beyond 2017. In fact, Japan is potentially decades away from its desired inflation target and, even if it is reached, it will have to be sustained for a period of time before the idea of stopping QE can be fathomed. Being the guinea pig for QE has meant the BoJ has faced a great deal of criticism, including claims that it waited too long to implement QE and tightened monetary policy too quickly. For the unwinding of QE, maybe the BoJ will wait for the Fed to move so they can learn from its mistakes.

An International Monetary Fund (IMF) paper by Hiromi Yamaoka and Murtaza Syed called ‘Managing the Exit: Lessons from Japan’s reversal of Unconventional Monetary Policy’ looked at what we can learn from the BoJ’s first QE exit strategy. This paper found that the gradual and orderly way in which the BoJ unwound QE in 2006, with clear indications given to the market, did not result in any obvious disruption to financial markets.

This proved that “it is possible to exit from a period of QE in a smooth manner, without overshooting of inflation, derailing economic recovery, or destabilizing financial markets.”[2]

Nevertheless, with the arrival of the global financial crisis the BoJ was forced to enter another monetary easing phase, having only raised rates back to 0.5% leaving the exit incomplete and Japan with a persistently weak pricing environment. It feels like years since ‘normal’ economic conditions have been here in Japan – maybe they will surprise us all and move first again?

Mark Burgess 11 July

Article also available in : English EN | français FR

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