Quan­ti­ta­tive eas­ing is not so fright­en­ing as mar­kets slump

Gulf Times Business - - BUSINESS -

US Pres­i­dent Don­ald Trump is not alone in blam­ing the Fed­eral Re­serve for this week’s tum­ble in stocks, as many in­vestors at­tribute the ebbing of easy money for spurring an out­break of mar­ket tur­moil.

With Bloomberg Eco­nom­ics declar­ing Oc­to­ber as the month the world’s ma­jor cen­tral banks to­gether start run­ning down their bond hold­ings, the with­drawal of liq­uid­ity is be­ing blamed in part for the sum­mer sell-off in emerg­ing mar­kets, the high­est 10-year US Trea­sury yield in seven years and now the big­gest drop in stocks since Fe­bru­ary.

What’s at risk of get­ting lost in the fo­cus on the shift by cen­tral banks to quan­ti­ta­tive tight­en­ing from quan­ti­ta­tive eas­ing, how­ever, is how ac­com­moda­tive they still are – and are set to be for some time to come.

Even as they stop, slow or re­verse their buy­ing of bonds, Bank of Amer­ica Corp reck­ons the com­bined bal­ance sheet of the Fed, Euro­pean Cen­tral Bank, Bank of Ja­pan and Bank of Eng­land will be just 4% smaller by the end of 2020. That means plenty of liq­uid­ity left slosh­ing around the global fi­nan­cial sys­tem and sup­port­ing the world econ­omy.

“We are wor­ried about a lot of things – trade wars and oil sanc­tions come to mind – but we are not wor­ried about quan­ti­ta­tive tight­en­ing,’’ Ethan Har­ris, chief econ­o­mist at Bank of Amer­ica, wrote in a re­cent re­port to clients ti­tled “Quan­ti­ta­tive Fright­en­ing.’’ Har­ris, who pre­vi­ously worked at the New York Fed, says still-large bal­ance sheets sug­gest “a lim­ited bond mar­ket sell-off and lim­ited spill-over into other as­set classes.’’

As for in­ter­est rates, which Trump said on Wed­nes­day the Fed has been “go­ing wild” on, the US bench­mark re­mains well be­low his­tor­i­cal av­erag- es. The Fed’s pol­icy rate is only barely pos­i­tive, af­ter ad­just­ing for in­fla­tion, while nom­i­nal rates – let alone real ones – re­main neg­a­tive in the euro area and Ja­pan.

In­deed, an av­er­age rate for de­vel­oped-mar­ket bor­row­ing costs compiled by JP­Mor­gan Chase & Co econ­o­mists only rose above 1% last month for the first time since 2009. Even 12 months from now, its fore­cast at about 1.5 per­cent­age points be­low the av­er­age of the two years be­fore the fi­nan­cial cri­sis.

For now, that may be lit­tle com­fort for Trea­suries in­vestors con­tem­plat­ing a rare an­nual loss. The 2.5% slide in the Bloomberg Bar­clays US Trea­sury In­dex so far in 2018 puts it on course for the first drop since the 2013 ta­per tantrum, and only the third since 2000.

The slide in Trea­suries, which sent the 10-year yield as high as 3.26% on Tues­day, added to the un­ease for stock in­vestors. With money-mar­ket funds now yield­ing real re­turns, the bar is higher to in­vest in riskier as­sets, the think­ing goes.

The S&P 500 In­dex tum­bled 3.3% on Wed­nes­day, the most since Fe­bru­ary. High-yield cor­po­rate bonds fell, though re­cent losses only take them back to mid-Au­gust lev­els.

The re­treat from riskier as­sets could get a whole lot worse in the eyes of those warn­ing that the QT cam­paign could be more ag­gres­sive than most as­sume.

Mor­gan Stan­ley strate­gists warned clients this week of a 1987-style dis­rup­tion. Back then, the Fed had been hik­ing rates, then West Ger­many’s Bun­des­bank sud­denly shifted pol­icy, fu­el­ing in­ter­na­tional eco­nomic ten­sions. And that was the back­drop for the 20% slide in the S&P 500 on Black Mon­day.

Fast for­ward to this week, and ECB Gov­ern­ing Coun­cil mem­ber Klaas Knot said pol­icy mak­ers may con­sider speed­ing up the process of re­mov­ing their ex­tra­or­di­nary stim­u­lus if the euro- area econ­omy meets their pro­jec­tions.

“Risky as­set mar­kets may head to­ward trou­bled wa­ters,” Hans Redeker, global head of cur­rency strat­egy at Mor­gan Stan­ley, and his team wrote in a note.

While a heated de­bate rages on whether QE did much for economies once cen­tral banks had staved off a 1930s-scale fi­nan­cial col­lapse, there’s no ar­gu­ment that the ef­fort has been gar­gan­tuan.

The big cen­tral banks in­creased their cu­mu­la­tive bal­ance sheets four times over, with the Fed’s alone top­ping $4tn – equiv­a­lent to 20% of US gross do­mes­tic prod­uct. Ja­pan’s hold­ings are on course to soon pass the level of GDP.

The Fed started shrink­ing its bond port­fo­lio a year ago. The ECB is plan­ning to halt its as­set pur­chases at yearend, a step the BoE has al­ready taken, although nei­ther has out­lined when it will hit re­verse. The BoJ has pared back its buy­ing, but is set to keep pump­ing out money through next year. Put it all to­gether and econ­o­mists an­tic­i­pate the bond port­fo­lios are set to stay bloated for a long time - and much big­ger than be­fore the cri­sis. Cor­ner­stone Macro pre­dicts the Fed’s hold­ings will only shrink about 40% as much as they ex­panded.

Ul­ti­mately, the im­pact of pol­icy nor­mal­i­sa­tion could be a ro­ta­tion within as­set classes, rather than a whole­sale exit towards cash. That sug­gests a shift to­ward fi­nan­cial stocks as in­ter­est rates rise, with groups like tech­nol­ogy strug­gling. Other piv­ots could come in fixed in­come; JP­Mor­gan Chase has high­lighted how bond is­suance skewed to­ward lower-rated com­pa­nies and longer-dated se­cu­ri­ties in the QE era.

For many, it’s all part and par­cel of any mon­e­tary tight­en­ing cy­cle.

“Quan­ti­ta­tive tight­en­ing is a phrase I hear of­ten,” said Roberto Perli, a part­ner at Cor­ner­stone and a former Fed of­fi­cial. “But there’s noth­ing to worry about. It’s not go­ing to be that large.”

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