Readers will doubtless be familiar with the concept of Quantitative Easing (QE). It involved the creation of digital money by central banks to buy financial assets, primarily, but not exclusively, government bonds.
QE pushed bond prices higher as investors scrambled to buy ahead of others, knowing that the central bank would always be there to buy, whatever the price. As bond prices increased, this had an effect on other asset prices too. Participants who sold bonds were forced to reinvest the proceeds in riskier assets in order to achieve a similar level of income rather than hold cash which yielded little.
The theory behind QE was that strengthening asset prices and lower interest rates would help to create confidence and stimulate business activity. The whole process led to virtually all risk assets spiralling higher but at the same time distorted the entire investment landscape, stretching valuations of certain asset classes to extreme levels. The economic impact was less dramatic as GDP growth has been uninspiring, although in truth it is impossible to say how things would have transpired in a world without QE.
An early form of QE had been pioneered by Japan in 2001 in order to try to stimulate inflation. Following the global financial crisis of 2007-2008, other countries, notably the US and Europe, implemented their own programs in order to offset the slowdown in financial markets. Japan instituted further QE and there were also smaller programs in the UK, Switzerland and Sweden. Central bank balance sheets expanded to around $15tn in 2018.
The below chart focuses specifically on the effect of the US QE, including Treasury bonds and Mortgage-backed securities, launched by the Federal Reserve (Fed), arguably the world’s most influential central bank, on the US stock market. It demonstrates that there has been a very strong correlation between the amount of assets held on the Fed’s balance sheet and the S&P 500 index.
Source (Federal Reserve Bank of St Louis, Capital IQ)
Meet Quantitative Tightening
Treasuries and mortgage-backed securities held by the Fed peaked at $4.25 trillion in September 2017. This has now dropped to $3.86 trillion at the start of 2019, a fall of around $400bn as the Fed has started to unwind QE in a process called Quantitative Tightening (QT). Essentially QT is the opposite of QE. As the Fed’s bond holdings mature, it is simply letting them expire naturally, raising around $50bn a month. The Fed is stepping back from any investment in new bonds which the Treasury issues and is allowing its position to decline over time. It is perhaps not coincidental that the US equity market has started to display an increase in volatility in the final quarter of 2018 at the same time that QE has started to be unwound. There has also been a rise in credit spreads as riskier bonds have come under pressure, with QT reversing some of the effects of QE.
The Fed is acting now because it has judged that the underlying economy is stronger and does not require emergency support. We believe that it is the responsible course of action following a period of extremely loose monetary policy. The Fed is concerned that low interest rates and QE have distorted the market and encouraged too much speculation, evidenced by the general decline in credit standards. This can create instability in the future if it were allowed to continue indefinitely.
It is possible that the Fed will pause or even abandon its new QT policy. In a recent speech, Jerome Powell, the chair of the Fed, suggested that it may make modest adjustments to its policy. Any scaling back of QT would doubtless be welcomed by financial markets. However, the Fed under Powell has to date been more focused on the performance of the underlying economy as opposed to the financial markets, quite unlike his recent predecessors. We would not therefore expect any very significant deviations in policy in the short term.
It is possible that the Fed will pause or even abandon its new QT policy. In a recent speech, Jerome Powell, the chair of the Fed, suggested that it may make modest adjustments to its policy. Any scaling back of QT would doubtless be welcomed by financial markets. However, the Fed under Powell has to date been more focused on the performance of the underlying economy as opposed to the financial markets, quite unlike his recent predecessors. We would not therefore expect any very significant deviations in policy in the short term.
The European Central Bank (ECB) has followed the Fed’s lead by announcing the end of their €2.6tn QE programme in December last year. Other central banks have to follow the Fed or risk a credibility issue and the prospect of capital flight. The other major QE player, the Bank of Japan, has no formal plans to end its QE just yet.
When the Fed’s balance sheet peaked in September 2017, it owned around 17.5% of all outstanding Treasuries. Investors were concerned that without support from the Fed, prices would fall sharply. The fall in prices has not, however, been as dramatic as some predicted. Ten year US Treasury bond yields have risen from 2.2% to around 2.7% today as the Fed’s ownership has dropped below 15% of the overall market. Given the benefit of income and currency gains on the dollar, UK investors in Treasuries will be broadly flat over that period. We believe that part of the resilience is down to the fact that yields on US Treasuries still look attractive on a relative basis. When the ECB, and the ultimately the Bank of Japan, normalise their QE programmes, we believe that this could lead to more volatility with government bonds in those regions, simply because yields are much closer to zero. Without central bank support, they will look relatively unattractive. These factors also help to explain the continued strength of the US dollar and why it is likely to remain dominant in the medium term.