Insights Q3 Outlook: QE to infinity and back
The past few months have seen a reality check on earlier market expectations of quantitative easing (QE) infinity – the idea that quantitative monetary easing by major central banks would go on forever, allowing us to lean back and enjoy an everlasting carry trade. Instead, US Federal Reserve chairman Ben Bernanke decided to teach markets a new word – tapering.
News that the Fed would taper or gradually reduce its monthly bond purchases under QE3 did not go down well with financial markets in May and June. Interest rates rose across the board, equity markets fell and the segments of global financial markets that perhaps had benefitted the most from a search for yield, particularly high yield and emerging market bonds, all fell sharply. The price of gold, long supported by the idea that central banks could be undermining the paper-based fiat money system, also continued its descent.
But let’s back up a bit and revisit what US monetary policy is trying to achieve. The federal funds target rate fell to its current low of just 0.25 percent in December 2008. With that, the Fed had effectively reached zero-bound, or the ability to impact economic activity through traditional channels. In trying to support the economy further and facilitate a balanced repair sheet for households and financial institutions, the Fed embarked on a series of quantitative easing programmes: QE1, QE2, operation twist and – since September 2012 – QE3. Under QE3, the Fed has been buying a record amount of bonds worth USD 85 billion per month, or more than USD 1 trillion a year.
By most accounts, US monetary policy has contributed not just to an economic recovery, but also to a more expedient restructuring of the financial sector than we have seen in Europe, or what we saw in Japan in the 1990s. However, an aggressive monetary policy is not without adverse side effects and as the economy recovers, it is natural for the Fed to consider terminating the QE programme. Further, in light of a significant improvement of the US budget position and hence a reduction of the bond issuance, a lowering of the Fed purchases seems entirely appropriate. Finally, unlike prior to the financial crisis, responsibility for regulation of the banking and financial sector now lies with the Fed and it cannot to the same extent ignore signs of “irrational exuberance” in financial markets. So, back to the present. From numerous Fed comments since the initial warning on May 22, there is a fair degree of certainty that a reduction in the monthly bond purchases will commence this year and will end altogether sometime in the first half of 2014. For bond markets, the most likely result will be a gradual rise in yields. However, as long as the funds rate is anchored at just 0.25 percent and with core inflation close to 50-year lows, a rapid rise in yields seems unlikely.
But when is the federal funds rate likely to rise? The Fed has conditioned a rise in rates on a decline in unemployment to 6.5 percent (currently at 7.4 percent) and a rise in inflation to 2 percent (currently, core PCE is just 1.05 percent). Of the two, the target for unemployment is more likely to be reached, whereas inflation is set to remain very low. We think the first rate hike will be delayed to 2015. Currently, federal funds futures price a rate hike of close to 75 basis points by end-2015. Implied probabilities now have a more than 40 percent chance in favour of a rate hike as early as December 2014. In short, markets seem well prepared for monetary policy changes.
Arguably, the greatest impact will be away from government bond markets. For instance, each QE programme has coincided with persistent gains in equity prices, just as the periods between the QE programmes have seen stock market declines. If the Fed is right in its forecast of a sustainable recovery, there is no reason to expect a persistent decline in equity markets, where continued economic progress and earnings growth will be key in terms of making the most recent period just another correction. Nonetheless, turning off the QE autopilot must be expected to influence relationships between sectors and to reduce expected returns. A tapering of QE may also spell trouble for the asset classes that have seen the largest capital inflows in recent years, particularly corporate and emerging market bonds.
Europe’s stable outlook
In Europe, the outlook for monetary policy is stable. We expect the European Central Bank (ECB) to keep policy rates at record low levels for the foreseeable future, with a bias towards further rate cuts. We also think the ECB will continue to explore other avenues through which to ease liquidity conditions in an attempt to support an economic recovery, counter the contractive impact from fiscal policy and facilitate a further balance sheet repair. In contrast to the US, much has been achieved in Europe from a verbal commitment to do “whatever it takes”. While the outright monetary transactions programme designed to keep market tensions in check has been brought into question in Germany, we expect the commitment to intervene in peripheral bond markets to remain. More specifically, we see the ECB going down two different routes. We can see a new round of very long-term repo operations designed to anchor interest rates, as well as changes to collateral and haircut rules. Negative deposit rates are a possibility, but will probably be dependent on a rise in EUR ’s value. The other route involves asset purchases, including asset backed securities to facilitate increased lending to small and medium-sized enterprises (SMEs). Further out, there is still a banking union to deal with, although little will move here until after the German election.
The Fed may be thinking about taking the foot off the monetary gas pedal, but the Bank of Japan (BoJ) has put the pedal to the metal this year. A change in policy by the least independent of the G3 central banks was already pre-announced by incoming Prime Minister Shinzo Abe last year. Under the leadership of the new BoJ governor Haruhiko Kuroda, the central bank said in April it would be doubling its monthly bond purchases to JPY 7.5 trillion, equal to 70 percent of government bond issuance and effectively doubling money supply in two years. Kuroda also pledged to achieve a 2 percent inflation target within two years, ending years of deflation.
The BoJ’s new strategy is nothing if not radical. A sharp rise in break-even inflation rates and a decline in the value of the JPY suggested early on that the policy was seen as credible.
Combined with an easing of fiscal policy and structural reforms, Japan appears more dedicated to lifting economic activity than it has for years. Whether it will work is another matter. The bank has experimented with QE since 2001, so far with little success. The BoJ is essentially running printing presses to finance budget deficits, thus increasing the risk of hyperinflation. Currently, however, the Japanese economy is moving in the right direction. Overall, monetary policy is set to remain extremely accommodative in the coming years.
Global monetary policy has undergone substantial changes since the financial crisis and the great recession. In truth, major central banks are experimenting with monetary policy on a scale not seen in generations. It is difficult to argue that aggressive easing has resulted in higher activity levels, but at the same time it is probably true that we would have been worse off without the interventions. So far, there is little evidence that the expansion of the money base is resulting in inflation. What we do know, however, is that central bank intervention is making price discovery in financial markets difficult, to the point that it can be hard to know what the fair value of interest rates and equity markets would be if central banks stepped back. That thought caused turmoil in markets during May and June. It seems clear that G3 central bank policy will begin to diverge in the coming year. The Fed is an early mover and while it will begin to lower its asset purchases this year, it will, together with the ECB and BoJ, keep policy rates at record lows well into 2015.