QE is defined as the expansion of the Central Bank Balance Sheet through the purchase of assets with electronically generated cash. In theory, QE is intended to alter the behaviour of financial market participants and thereby the real economy, by rebalancing investors’ portfolios out of cash into non monetary assets ( such as Bonds, Equities or Real Estate); altering long term interest rate expectations; and, via the announcement effect, having a positive impact on confidence in financial markets and the real economy. Since the collapse of Lehman Brothers on 15th September 2008, the US Federal Reserve (the Fed) has been buying bonds from the public with electronically created cash to the tune of US $3 trillion (tn).
The first round of QE was courageous, ad hoc and reactive, unpinned by theory and focused solely on unfreezing financial markets and was highly effective. Central Bank bought a variety of unloved instruments but with an emphasis on mortgage – backed and related paper, where the loss of confidence in their external credit ratings had created most paralysis. Measures of market stress that had been reaching for the skies in October 2008, such as interest-rate spreads between government paper and high yield or bank debt, turned sharply lower by March 2009.
Subsequent rounds of QE did not have a direct impact on activity, but had an indirect role of signalling that interest rates would remain low for as long as QE was in force. Consequently, the announcement at the 22nd May 2013 press conference by Fed Chairman Bernanke that the Fed could start tapering QE, was a major change of signal, suggesting that interest-rate policy would soon change. This caused a market disruption that lasted some four to six weeks.
Practicalities of unwinding QE
Central banks could broadly do three things with their holdings of securities. First, they could sell them back to the market, presumably when conditions are ripe: the monetary transmission process from interest rates to lending have been repaired, economic activity has returned and there are signs of the previous monetary expansion contributing to inflation or overheating of asset markets. The Central Banks would receive cash for their sales, which they could then electronically delete, shrinking back their balance sheets. There could be a net loss from the purchase and resale if in the meantime interest rates have risen, as would be expected if conditions had normalised. The UK government has formally agreed to meet any loss and similar arrangements are like to be formed elsewhere. Given the size of these holdings, the potential for market disruption from a policy of sales and the fear of that potential, suggests asset sales would be delayed and managed carefully. It would be quite wrong to suggest that while a rapid expansion of the monetary base was only partially effective at reviving activity, there is no need to worry about the timely reversal of the expansion. Expansion and contraction are unlikely to be symmetrical.
Second, Central Banks could hold the securities to maturity. In principle this would have a similar monetary, balance sheet and cash impact of selling them back as it would be likely that the government would have to issue new securities into private hands to meet principal repayment due on the bonds held at the Central Bank. However, with the average maturity of current holdings at Central Banks approaching seven years, this process would be drawn out. This would appear to the least disruptive option for markets, but it can be argued that its delay would raise inflation risks.
Another possibility is for the Central Banks to reach agreement with their respective governments to cancel the bonds. This would have the positive impact of lowering government Debt to GDP ratios by as much as 20 ppts, removing one of the the perceived obstacles to economic recovery – market anxiety over fiscal sustainability. Essentially, this would mean that the Government financed its deficit by printing cash. Cancellation would also complicate the balance sheet of the Central Bank. One alternative, that would have a similar cash flow effect, would be for the Central Bank to swap the interest-bearing, fixed term, government bonds on its balance sheet for an interest free, perpetual bond.
Effects of QE and its unwind on financial markets
The possible major risks and their key components are as under:
Default risk: If QE succeeds in stimulating the economy then the rate at which risky companies fall should fall. Furthermore, as the economy recovers, investor pessimism (risk-aversion) over the quality and sustainability of current earnings will fall, also lowering measures of default expectations.
Inflation risk: To the extent to which QE simply passes through to higher prices or expands demand, QE may increase short or long-term inflation expectations. At the very least it may reduce the risk of a short-term deflationary spiral. Alongside higher inflation risks or lower deflation risks is greater uncertainty over the range of possible outcomes. This may lead to an increased uncertainty premium. All of these factors could serve to increase, rather than reduce, long-term interest rates.
Liquidity risk: QE essentially involves replacing long-dated or illiquid securities with increased reserve balances, thereby increasing the liquidity in the hands of investors and decreasing the liquidity premium. Where the focus of QE is on the purchase of non-government paper, it is important to note that the effect of such a reduction may be an increase in government bond yields since they no longer benefit from the demand for liquidity during times of crisis.
Duration risk: By purchasing long-dated bonds, the authorities will reduce the duration risk in the hands of investors (by moving that risk on to the Central Bank’s Balance Sheet) thereby altering the yield curve and lowering long-term interest rates.
Market risk: A QE policy is itself a signal of a commitment by the Central Bank to keep interest rates low which should in turn lower long-term interest rates.
The result of QE is most directly and immediately seen in the instrument or instruments being purchased. It is important to differentiate the effects of the announcement of QE and the impact of the actual purchases. A consensus of the empirical analysis is that QE has lowered medium and long-term interest rates by a little less than one percentage point, but it is less clear precisely which of the channels listed above this reduction is working through. During the first round of QE (QE 1), there were yields falling across a range of fixed income instruments, medium term and long term, government and non government bonds. The large reduction in mortgage rates appear to have been driven by the fact that the QE1 involved the purchase of mortgage backed securities (MBS). Financial markets interpreted QE2, which was focused on long-term government paper, as signalling lower future federal fund rates.
An important issue is whether the announcement of QE measures in one economy contributed to easier global liquidity conditions in global financial markets. There is a common perception that QE led to a wall of money that bought up risk assets, but there is no evidence backing this up. QE did not have material effects on global financial markets, separate from the powerful effect of lower interest rates. Lower interest rates in the USA, Euro zone, Japan and the UK influenced global financial conditions, risk-pricing and exchange rates and so far as QE was a signal of how long these low rates would last, QE helped to transmit their effects. During QE1, two – yields in emerging Asia, for instance, fell by about 45 bps, 10 year yields by 80bps. The effect of QE2 was less pronounced as expectations of low interest rates for a long time had already bedded-in, though in both the cases Corporate Bond yields fell further, though this could have also indicated a further reduction in market and liquidity- risk premia as markets stabilised. When there is a return to some stability and there is a belief that wide rate differentials will endure and will press high-yielding currencies higher, an attractive investment strategy is to borrow cheaply in the economy pursuing QE and invest in the emerging economy. These so called “Carry-trades” resulted in capital flows into emerging economies, boosting prices, lowering yields and thereby easing financial conditions in emerging markets. The spillover effects from US monetary easing are hard to avoid, particularly where there are dollar-linked exchange-rate arrangements. The extent and impact of spillover effects are notoriously hard to quantify, given the varying strength of cross-border transmission channels and the differing conditions of the effected economies.
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