Cash flood dries up as QE turns to QT
A decade on from the financial crisis, central banks start to switch from easing to tightening
After a decade of relentless central-bank moneyprinting, it’s difficult to imagine how markets and the world economy could have crawled away from the wreckage of the financial crisis without quantitative easing (QE).
The first rounds were uncharted territory: policymakers injected liquidity into the financial system by buying trillions of dollars of government bonds, pumping in money to stimulate the economy.
Balance sheets at the United States Federal Reserve, the European Central Bank and the Bank of England ballooned and markets became dependent on the programme.
Now the Fed has become the first to step into another unknown. The US central bank is unwinding its experiment and stricken markets are the unwilling guinea pig.
This year will mark the first time global central banks’ balance sheets will shrink, dropping to an estimated US$14.6 trillion ($21.3 trillion). More than US$1.2 trillion will have been sucked out of the financial system by the end of the year since QE’s peak in early 2018, according to data from Hermes Investment Management.
Investors fear winding down the Fed’s US$4.5 trillion balance sheet is quietly strangling the life out of markets. Quantitative tightening (QT) — the reversal of QE — has become fund managers’ second-biggest concern after the trade war, according to Bank of America Merrill Lynch.
They fret that central banks could trigger a liquidity drought that will finish off the floundering bull run.
Some observers believe it was no coincidence that turbulence on financial markets in the last quarter of last year coincided with the moment that QE tipped into QT globally.
In QT, central banks either let their portfolio of bonds mature or sell the debt. The Fed has allowed as much as US$50 billion a month of its balance sheet of bonds to mature, taking money out of the system as government debt finds new buyers. The European Central Bank also joined the Bank of England in turning off the QE taps in December. Their balance sheets remain steady.
“We are seeing this giant sucking out liquidity from the system with the Fed raising rates and reducing the balance sheet,” explains Eoin Murray, head of investment at asset manager Hermes. “The tipping point was October. From October onwards, net global liquidity was starting to decline and that is quite important.”
Central banks kept yields on debt low through QE, and their withdrawal from bond markets is making borrowing more expensive for firms.
The reversal of QE will make spikes in market volatility, as seen in the final quarter of 2018, more likely, warns Seamus Mac Gorain, investment manager at JP Morgan Asset Management.
Investors fired a shot across Fed chairman Jerome Powell’s bow in December. The market bloodbath gathered pace amid fears that the Fed’s heavy-handed approach would pull the rug from under investors.
Powell shocked markets by admitting that reversing QE was on “autopilot”. The December rout that pushed US markets to the brink of a bear market forced a hasty retreat last week. He said: “We wouldn’t hesitate to change it [policy] and that would include the balance sheet.”
Powell could prove a thorny adversary for markets, however. He revived concerns last week by warning that the balance sheet will be “substantially smaller”, suggesting further tightening ahead.
We are seeing this giant sucking out liquidity from the system.
Eoin Murray, Hermes Investment