QE: It’s the monetary policy, stupid

By:
Louise Bowman
Published on:

Central bank risk, not political risk, should be bond investors’ primary focus.


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Total assets held by the world’s major central banks stood at $18 trillion in April 2017.

This incredible figure includes the $4.9 trillion assets held by the People’s Bank of China. Aside from that, the Fed accounts for $4.43 trillion, the European Central Bank (ECB) $4.44 trillion and the Bank of Japan $4.52 trillion.

How this phenomenal volume of financial assets is eventually unwound is now perhaps the most important issue facing bond investors.

Indeed, while the markets wait for the first signs of a reduction in the Fed’s balance sheet next year, it is worth remembering that the US central bank now poised to exit quantitative easing (QE) actually has the smallest balance sheet of the lot.

The trillion-dollar question is whether or not the markets are prepared for the end of QE. Despite the market uncertainty that Donald Trump’s election precipitated, the Fed has so far rigorously stuck to the playsheet: having hiked twice since the election, a third rate hike in June is now priced in.

The adjustment in rates must be well under way before they do anything on the balance sheet, so they are widely expected to announce tapering of the actual balance sheet in December.

Some portfolio managers are confident that this ultra-cautious, ultra-gradual approach means that any repeat of 2013’s taper tantrum is off the cards. Others take the view that if you can’t predict events or the market’s reaction to events then you cannot be properly compensated for the risk that you are taking. So you shouldn’t take any.

The only thing that both sides agree on is that as markets obsess over political risk, it is central bank policy that should really be their uppermost concern.

Naive

As one London-based fund manager points out, so far there have been zero successful exits from QE. None. So, to anticipate the smooth and untroubled unwind of trillions of dollars-worth of stimulus is wildly naive.

Once bitten by the taper tantrum of 2013, the Fed will certainly be extremely cautious in communicating its intentions to the market – but will that be enough?

The market mantra is that because there is nowhere near the amount of leverage in the system that there was in 2007, the kind of disruption that was precipitated then is now out of the question. What it really means is that if there were to be significant market disruption, the central banks would be happy to stand by and watch institutions fail because so much of the risk is now outside the banks and therefore no longer systemic.

As one portfolio manager recently warned: “If bond investors believe that the central banks will bail them out of any losses, then they are sadly mistaken.”

The success or otherwise with which QE is unwound will be dependent on the market’s confidence in the central banks’ own ability to manage the process. If a point is reached where investors lose confidence, for example due to a rapid rise in inflation or economic slowdown and deflation, that is where discipline might break down.

If US rates start to rise more rapidly than anticipated or there was unexpectedly worrying news from China, then all the central bank telegraphing in the world isn’t going to placate anxious investors.

In Europe, the ECB has now signalled the end of QE-infinity and is starting to suggest a timetable for unwinding its asset purchases – two or three years later than those of the US. QE will likely continue until the end of this year with tapering in 2018.

The ECB faces a big output gap and inflation is very low so it is difficult to see the central bank continuing to grow the balance sheet in 2018. If European interest rates start moving at the end of next year, the balance sheet still won’t shrink until 2020 or 2021.

For many European investors, the prospect of an end to QE is therefore still so far off that there is little need for caution: Europe is still a spread compression trade. Others see conditions that are more conducive to a market unwind than at any time since the financial crisis.

Ready to reload

Only time will tell who is right, but the ability to react as and when any correction comes is clearly hugely important. Some investors are, therefore, carrying unprecedented volumes of cash so that they are ready to reload the gun when such a value opportunity presents itself.

There is little sign of alarm yet. European investment-grade spreads are now back to where they were immediately before the crisis, but the risk that investors are having to take on to be paid those spreads has sharply increased.

A look at the rating split of the EUR IG index at the end of December 2007 would have revealed 9.2% of the index as triple-A rated, 35% double-A rated, 37.5% single-A rated and 18.3% triple-B rated. A look at the same index at the end of March 2017 reveals that just 0.5% of the index is triple-A rated, 11.7% double-A rated, 40.1% single-A rated and 47.7% triple-B rated.

That is a very different risk profile for the same reward.

Indeed, spreads are now so low that there is no cushion for bondholders when the unexpected happens. When medical technology company Becton Dickinson recently announced an exchange offer in connection with its offer for CR Bard, its bonds lost between 5.5% and 6% in a single day.

Institutional investors might not be systemic, but the pension schemes that they invest face growing deficits – which a significant backup in bond yields would help to close.

This cannot be completely ignored by policymakers who face a fiendishly difficult task in withdrawing QE, managing inflation and keeping the confidence of a jittery investor base with little room for manoeuvre.

It will be a formidable balancing act.