Central banks are set to unwind the extraordinary accommodation put in place since the global financial crisis. The US Federal Reserve (Fed) has commenced its transition from Quantitative Easing (QE) to Quantitative Exit and the European Central Bank (ECB) is preparing to taper asset purchases.
This Macro Insights follows up on the Outlook we released in July with a deep dive into the potential asset implications of the global QE retreat. GSAM investors discuss the key variables they’re watching that may alter the policy calculus and the market’s response to this watershed event.
Where Did QE Take Us?
Central bank asset purchases dampened risk premia and market volatility, while bolstering valuations for risk assets, including corporate credit and equities.
Central bank purchases of primarily sovereign bonds exerted downward pressure on term premiums of longer-term securities. This could reverse as QE is unwound.
We expect bond yields to rise from depressed levels as central banks transition to less accommodative monetary policy. That said, the downward pressure on bond yields precedes QE, in part due to factors such as the global glut of savings and so the upward trend will be gradual.
Low government bond yields prompted portfolio rebalancing, encouraging investors to move further out the risk spectrum to find yield. This global "hunt for yield" has supported risk asset prices and driven spreads towards their historical tights.
Unlike private investors, the Fed does not hedge interest rate risk on its holdings of agency MBS. Returning agency MBS ownership to the private market could drive rate volatility meaningfully higher.
We sat down with three of our investors to discuss how the QE unwind will play out and what events could buffer or exacerbate the market’s response.
What could buffer the impact of the QE unwind?
Beinner: QE is an unconventional policy, implemented in extraordinary times, which may explain why we saw such marked asset price reactions. In contrast, the QE unwind is occurring as economies normalize with low inflation and synchronized growth.
Less accommodative policy also does not imply tight policy. So far, the Fed is the only major central bank to begin a balance sheet runoff, while the ECB and BoJ continue with their QE programs, albeit at a reduced pace. Thus, the "stock" of global QE purchases is still expanding, though as noted in our Outlook, the peak "flow" of asset purchases is behind us. We may see more pronounced market moves as asset purchases grind to a complete halt, though we do not expect this until beyond 2018.
Nuttall: This concept of "stock" and "flow" has important market implications. Even the slightest hint around a change in the pace of asset purchases can trigger acute market reactions, which the Fed discovered after the 2013 Taper Tantrum. Central banks have since refined communications and we now obtain guidance in the form of press conferences and speeches before official policy meetings. The well-telegraphed strategy has worked to minimize the "announcement effect."
Stiles: I would note two additional considerations. First, in Europe, the ECB will maintain low policy rates "for an extended period of time, and well past the horizon of the net asset purchases." This will keep European government bond yields anchored. Second, even as central bank liquidity fades, other forms of liquidity could keep a lid on government bond yields—from the excess savings of emerging market economies to liquidity from private sectors of developed market countries. Market participants have deployed these savings in assets, such as US Treasuries, which may continue to prop up developed market asset prices even as central bank liquidity wanes.
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