From QE to QT: Whither global liquidity?
The long road from financial crisis to recovery passed another milestone in
September when the US Federal Reserve (Fed) announced that it would start to
reduce its $4.5 trillion balance sheet from October. The asset purchase programme,
or Quantitative Easing (QE), is finally being unwound with the US central bank set to
allow maturing bonds to run off its balance sheet rather than continuing to roll
them over.
The process will start slowly with an initial $10 billion of Treasuries and mortgage
backed securities (MBS) being allowed to run off per month. However this will step
up by $10 bn every three months until it reaches a cap of $50 bn per month. At this
point the actual pace of balance sheet reduction will depend on the flow of
maturing bonds, but it will mark a meaningful change in liquidity. The move toward
quantitative tightening (QT) has begun.
It is widely accepted that QE has played a role in boosting asset markets. By
depressing government bond yields, central banks have driven investors out along
the risk curve pushing up credit, equities and property along with a host of more
esoteric assets such as wine, classic cars, etc. The question now is whether turning
the process around and withdrawing liquidity will send asset prices into reverse.
In a world of efficient markets the shift from QE to QT would have minimal effect as
it would be fully anticipated by markets and so already priced in. Mindful of this, the
Fed has been fully transparent in their intentions by detailing the balance sheet
reduction process back in June. No one should have been surprised by the
announcement on 20 September. Although there was some re-pricing at the short
end of the curve, US Treasury and MBS yields barely moved in response.
Of course alongside the announcement on QT, bond markets also had to digest the
Fed’s comments on activity, revised forecasts for the economy and the famous dotplot
where Federal Open Market Committee (FOMC) members give their best guess
of the future path of interest rates. Although there was some excitement over the
fact that a majority of members are still looking to raise rates in December, the near
term outlook did not alter significantly compared with June.
For long term rates, perhaps the most important part of the dot plot moved in a
dovish direction with a reduction in the forecast for the terminal rate to 2.75%. The
latter has declined considerably in recent years from 4.25% in 2012 and might be
seen as an official view of the “new normal”, an important anchor for yields at the
long end of the curve. As private investors decide whether to refinance the bonds
which the Fed is no longer rolling over, these projections of equilibrium rates are
critical.
More generally, studies suggest that QE in the US has depressed bond yields
although estimates vary. The US Treasury Borrowing Advisory Committee reported
that adjusting for the path of short rates to capture the extra yield investors require
for holding longer term debt suggests that balance sheet normalisation would add
40 bps (basis points) to the 10-year term premium. However, recent research from
the Fed suggests a somewhat higher figure of 100 bps. 1
This would imply some modest upward pressure on US yields: whilst the Fed may
have distorted the curve, the outlook is still supportive of a low interest rate
environment given the decline in equilibrium rates and the likelihood that inflation
remains benign. Private investors such as banks, insurance companies and pension
funds will continue to price bonds with reference to these factors as they replace
Fed demand.
Will global liquidity continue to expand?
Whilst the Fed has reached an historic milestone, central banks elsewhere are
lagging behind with the Bank of Japan (BoJ), European Central Bank (ECB) and
Riksbank still fully engaged in QE. We estimate that central banks have injected $1.5
trillion of liquidity through asset purchases over the past year led by the BoJ and
ECB.
Our projections for central bank balance sheets are going forward as global liquidity will continue to rise. This is a positive for financial markets. However we believe that investors should start to become more wary on the benefit this will provide to risk assets, for two reasons.
First, the pace of liquidity growth will decelerate such that by the end of next year it
will be rising at half its current rate and will almost grind to a halt in 2019. Although
the BoJ is expected to continue with asset purchases over this period as it tries to hit
its inflation target, increasing QT from the Fed and tapering of QE by the ECB causes
a slowing in global liquidity.
In many respects the ECB move may prove to be the more important development
in 2018. The ECB’s programme has been larger as a share of GDP and domestic
markets than that of the Fed’s (see front page chart). As a result we have seen a
considerable squeeze on Eurozone sovereign bond markets where the ECB has
bought a large proportion of available bonds. German bund yields, for example,
have been driven down to eye watering levels. Rates have fallen across the single
currency area such that bond markets in France, Italy and Spain have seen record
lows.
Analysis of capital flows by Oxford Economics shows the significant impact this has
had with private investors selling their holdings of sovereign bonds and shifting
some €800 billion overseas (chart 4). In this way the ECB’s action had an
international impact. For example, one of the major beneficiaries has been the UK
government which received £35.2 billion of funding in the year to July through
Eurozone purchases of gilts.
The ECB is expected to step down its asset purchases from €60 billion per month to
€40 billion and then €20 billion, before ending QE in December next year. As the
ECB tapers QE we might expect a rise in yields across the Eurozone, thus bringing
investors back to their domestic bond markets and resulting in a reversal of
previous flows.
Higher yields in core economies will bring some relief to bond investors particularly
domestic insurance and pension funds. The risk though is that the more sensitive
peripheral markets could sell off considerably more than in the core. This is an
outcome which would be problematic for the Euro as markets re-focus on the
structural flaws within the region. The ECB does have tools to counter such an event
although in the absence of QE any support would become conditional on reform,
making progress more difficult and crisis more likely. In this respect ECB QE differs
from that in the US and elsewhere as it also indirectly serves the purpose of
quashing political risk premia in the periphery.
The second issue is whether we can compare QE across countries? In chart 2 above
we have converted each central banks QE into US dollars to calculate global
liquidity. However, this assumes that investors view bonds across countries as
perfect substitutes. In practice they are not as, along with regulatory restrictions,
investors also have to take account of potential currency moves when investing
overseas.
One way of overcoming this is to hedge currency exposure and we have used the
differential between short rates (1-year) as an indicator of hedging costs to compare
with the yield pick-up between bond markets (chart 5). When we account for
hedging the incentive to move capital out of Japan and the Eurozone has clearly
declined and now absorbs most of the yield gain from holding US bonds. This
reflects the increases in US short rates as rates in the Eurozone and Japan have
been stable.
So although capital can flow freely between countries and we might think of
liquidity in different regions as part of a global pool, in practice it can remain
contained domestically by factors such as currency. This would seem to be the case
at present. Put another way, at present US Treasury yields would have to rise
significantly for Japanese and Eurozone investors to shift into Treasuries given the
hedging costs.
The shift from QE to QT is a welcome development as it signals another step toward
normality after the global financial crisis. The Fed has been transparent in its
signalling and whilst bond yields in the US may experience some upward pressure
they should remain underpinned by the good behaviour of inflation and declining
estimates of long run equilibrium interest rates. Looking at the wider picture, even
with QT, global liquidity should continue to rise over the next 12 to 18 months
largely supported by the BoJ.
However, whilst all this is reassuring for markets and risk assets we would inject a
note of caution. First, the pace of liquidity expansion will slow as the Fed
implements QT and then as the ECB tapers QE. Moreover, ECB tapering may bring
bigger swings in capital flows and yield shifts given the impact of its QE on
portfolios. As core yields rise in the Eurozone there could be problems for
peripheral economies which no longer have the central bank backstopping their
sovereign bond markets.
Furthermore, we question whether we can talk of global liquidity when international
investors have to take account of currency and hedging costs in assessing returns.
The current configuration of interest rates may keep capital at home rather than
flowing freely from areas of QE to those with QT. The bottom line is that not all QE is
equal and although global liquidity will not dry up, it will start to wither as we head
into 2018.
Keith Wade, chief economist at Schroders
