As stock markets slowly recover from last year’s slide, discussions about the trigger for the sell-off still abound. Was it softening manufacturing data from China or its trade tensions with the US? Or was it everyone’s favourite scapegoat, the Fed, raising interest rates too aggressively? Another potential culprit that has not received as much attention in this search for a suitable narrative is the Fed’s reversal of its previous Quantitative Easing (QE) programmes. Via a process fittingly dubbed “Quantitative Tightening” (QT), the Fed has begun to shrink its balance sheet, which had more than doubled since 2009 from c. USD 2trn to c. USD 4.5trn by 2014. At the same time, the ECB has now phased out its own ambitious QE programme, which allowed it to purchase up to one third of bond issues in the European market.
In light of the recent stock market turmoil, parts of the financial community have argued that this takes monetary tightening too far, creating unnecessarily strong headwinds for risk assets and the wider economy.
Much of the reasoning as to why QT could constitute a major policy error rests on the assumed effectiveness of QE. It is true that if you chart the Fed’s balance sheet against the S&P 500, both steadily go up in tandem. But correlation does not imply causation – indeed, you would see the same co-movement if you plotted either of them against global carbon emissions. To conclude that QE was the main driver for stocks going up since they bottomed in 2009 ignores the fact that big corporates have been enjoying very healthy profit growth throughout that period. Moreover, savings and hence demand for financial assets remain high as populations around the world grow older and Asian countries look to recycle their trade surpluses.
It is harder to deny that QE has suppressed bond yields. The question is how large its impact has been and what this implies for a reversal of such policies. Let’s take another look at the Fed’s balance sheet against US 10-year treasury yields (see below). If the aim of QE was to bring down long-term interest rates in an attempt to boost asset prices, its success was mixed, as treasury yields still exhibited significant up-and-down swings while QE was in operation.
Those concerned about QT may well be overstating the impact of central bank intervention on long-term interest rates and the resulting effect on other financial assets.
Due to its larger scale relative to its economy, the ECB’s QE may have had a more pronounced effect. With the exception of Italy, government bond yields for Eurozone countries have been trading in a narrow range since the ECB initiated its own QE programme in 2015. But then again, if QE was such a key factor here, why has its phasing out not led to more upward pressure on bond yields thus far?
“Thus far” is a key qualification. The next big monetary experiment has only just begun, and as central banks proceed with tightening monetary conditions, the effects of raising short-term rates in conjunction with QT will become more visible. This does not only apply to equities and high-yield bonds, but also to the currency markets. The economy is a complex system, and just like the proverbial flap of a butterfly’s wings can cause a hurricane, QT may be the last bit of snowfall that sets off an avalanche. However, without further evidence, Quantitative Tightening will remain for now at the bottom of my worry list. At this point in time, ham-fisted actions by politicians and government executives seem like a greater risk to the world economy.
For more information, please contact Moritz Sterzinger, Director at JCRA, at email@example.com.