Should we worry about quantitative tightening?Contributor Vincent Juvyns
Quantitative tightening isn’t something to fear necessarily, but as central banks begin to take away the punch bowl, there should be an increasing focus on quality assets, those without unsustainable leverage.
Central banks are tightening monetary policy because the global economy is strengthening. So we shouldn’t necessarily fear either interest rate or balance sheet normalisation. However, quantitative tightening is likely to result in higher volatility. And companies, or governments, who have taken on too much leverage in the period of low interest rates, will be left exposed.
QE: Lower yields, lower volatility
In 2008, confronted with the worst financial crisis since the 1930s, the US Federal Reserve (Fed) decided to deploy an unconventional monetary tool-quantitative easing (QE). In the years that followed, central banks in the UK, Switzerland and eventually the eurozone all took similar measures, contributing to total monetary stimulus (including purchases by the Bank of Japan) to the global economy and its financial markets that has now reached USD 16 trillion (Exhibit 1, right hand side).
QE was designed to encourage investors to search for yield. By increasing demand for riskier assets such as corporate bonds, this lowered borrowing costs when the economy— and tax receipts and profits—were weak. Indeed, we estimate that QE programmes lowered the US government’s 10-year borrowing costs by approximately 100 basis points. Lower risk-free rates led to lower discount rates, which partially helped equity markets and also encouraged investors to look further out on the risk and maturity spectrum to obtain extra yield.
QE served to compress yields, but most likely also suppressed volatility. The European sovereign market is a clear example of this. When the European Central Bank (ECB) was an active buyer in European sovereign bond markets, investors were to a large degree insulated from political noise. In contrast, the election of a new populist government in Italy coincided with the tapering of the ECB’s QE programme, resulting in considerable volatility in the Italian bond market this year. In short, central banks are no longer actively “buying the dips”.
EXHIBIT 1: GLOBAL CENTRAL BANK POLICY
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