Mark Lister, 5 December 2017

Quantitative easing (QE) has been one of the most influential themes financial markets have seen in the years since the global financial crisis. Today, the first of the big central banks is gearing up to begin reversing that process.

It should be fairly simple to figure out what that could mean for financial markets. Just take the playbook of the last several years, and turn it upside down. That would mean interest rates heading back toward more normal levels, currencies of countries who embarked on QE rebounding, and some of the heat coming out of asset prices.

It won’t be quite that simple, but that’s the basic premise. QE held interest rates artificially low, had a negative impact on the likes of the US dollar and the euro, and bumped up the value of just about every asset that could be invested in.

The Federal Reserve in the US will be the first to move, while its counterparts in Europe and the UK might not be too far behind. They’ll watch with interest and see how things go for the Fed, before following a similar path.

Japan is in a slightly different position, so will not be in any rush. We expect the Bank of Japan to remain very stimulative for some time yet, a dynamic that will likely see the yen remain under pressure over the medium-term, and Japanese equities stay buoyant.

QE is one of two main tools central banks have at their disposal to tighten or loosen monetary policy. Most of us are familiar with the other, which is moving short-term interest rates up and down. In New Zealand, that’s where the Offical Cash Rate (OCR) comes in.

QE unwind table

QE is much harder to explain in just a few sentences. It’s when a central bank buys assets like government bonds and other securities from the private sector, and pays for them by creating reserves. This increases the size of its balance sheet, with the newly bought bonds on one side of the ledger, and a higher level of reserves on the other. This eases financial conditions by reducing interest rates right across the spectrum and also throwing out the market equilibrium, forcing private sector players to replace those securities with something else through portfolio rebalancing.

Experts will debate whether lower interest rates or the portfolio rebalancing effect have been more significant when it comes to rising asset prices. However, what is abundantly clear is that central banks have played a key role in higher prices for everything from bonds, to shares, to art and antiques.

The main way for the Fed to reverse QE is to simply wait for some of those government bonds it purchased to mature, and instead of reinvesting the proceeds to buy new ones, doing nothing. The US Government still needs the money to fund its outgoings, so it will still issue new bonds to replace the ones the Fed isn’t reinvesting in, but someone else in the market will have to buy them this time around. If a commercial bank does, the reserves they have at the Fed will go down as they pay for their new bonds.

That causes the Fed balance sheet to shrink a little, as the government bonds aren’t sitting in the assets column, and the corresponding amount of reserves have gone from the other side too. While this might sound somewhat confusing, the key point is that the central bank actions of the last several years are about to start moving in reverse.

QE unwind table 2

We don’t need to panic. This process will be very slow and gradual, and will take years, rather than months. The Fed appreciates this is somewhat uncharted territory, and will want to tread carefully. We could also see central bankers backtrack on this process, should they start to see problems looming.

It’s certainly not a bad thing that we are beginning to see the first steps toward a return to normality. It’s also a positive sign that some of the largest economies in the world now see it as the right time to start removing some of the economic life support that has prevailed over the past few years.

The US ISM Manufacturing index hit 60.8 in September. That is the highest we’ve seen since May 2004 and it’s well above the breakeven 50-level. The University of Michigan Consumer Sentiment index, which rose to 100.7 in October, is another example of the current strength of the US economy. This reading was the strongest since 2004, and is only the second time since 2000 that it has risen above 100.

We believe a gradual reversal of QE is a positive in the longer-term, as long as economic growth increases slowly and keeps up with these market changes. However, we should expect a steady move higher in global interest rates, a change in currency market dynamics, and a lower path of investment returns due to a few more headwinds in other asset classes.

Please note: This article was published in the December 2017 edition of News & Views under the title “The great unwind – Prepare for the reversal of QE”. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by clicking here.