ref :- "No need to get queasy about the unwinding of QE", David Smith's Economic Outlook in the Sunday Times, Business Section
Seems like an odd moment to reach back to the weekend's press... after all, it's not as though there's nothing going on. After yesterday's upbeat reaction to the US / Canada / Mexico trade deal (which President Trump will push as a vote-catcher but is not wildly different to the old NAFTA), it's all a bit dark and "risk-off" today as Italy and its budget rears its ugly head again. Well, it was always going to. The sparks that prompted today's moves were primarily : Head of Lower House Budget Committee Claudio Borghi saying that Italy would not be facing its current problems if it had its own currency ; and comments from EC President Jean-Claude Juncker that seemed to suggest that Italy might end up in the same bracket as Greece... Mmm, nice one, JC.
The markets' risk-off reaction ? Dollar higher , and so too the Jap Yen (finally)... Euro lower... stocks lower... Quality sovereign bond prices higher / yields lower, with entirely the opposite moves in Italy's debt. The yield on Italy's 10yr bond is out to 3.40% (a 4yr high), and is now 297 basis points above that of the German equivalent. You've got to have some sympathy for Finance Minister Giovanni Tria, who having originally tried to keep the 2019 budget deficit at no more than 1.6% of GDP now has the job of convincing both the EU and the markets that the deficit of 2.4% pushed through by the governing populist coalition is perfectly manageable. The showdown with Brussels is still to come, and this issue has a long way to run.
But back to QE...
Mr Smith's column is generally UK-focused, but the task of unwinding the vast asset purchases that have been the method behind Quantitative Easing is one that the Bank of England shares with the world's three largest central banks: the US Federal Reserve, the European Central Bank and the Bank of Japan.
QE, it should be remembered, was a measure brought in alongside slashes in interest rates as a result of the financial crisis of ten years ago with the aim of providing huge injections of liquidity just when the financial system most needed them. It was unprecedented, and controversial... some thought it just a measure to support the banks who had largely been responsible for the dire state of affairs in the first place (it wasn't). Many also saw central banks turning on the monetary taps in such a way as a sure-fire recipe for galloping inflation, or even hyperinflation. As we now know, they couldn't have been more wrong.
Perhaps the biggest reason behind QE not being inflationary is the fact that it is reversible. At some stage the central banks will (very gradually) withdraw the liquidity injected into the economy through asset purchases by releasing those assets back onto the market... or by NOT re-investing the proceeds of maturing bonds -- that at least should be the long-term aim of any central bank seeking to normalize monetary policy (and to give themselves some room to manouevre before the next crisis arrives). That reversibility fundamentally differentiates QE from simply printing money a la Weimar Republic, or Zimbabwe. Those who viewed QE as a magical way for a central bank just to create money electronically out of nothing that could be used for spending on schools, hospitals, roads, etc., etc., etc. were heading down the same route as the leaders of those two sad examples. (Trouble is, some of them still feel that way).
Despite the undeniable truth behind the accusation that an asset-buying programme must inevitably benefit those with the assets (the wealthy) more than those without -- and thus widen inequality -- on balance, QE must be judged a success. Or rather, a success SO FAR .... as it's impossible to say whether QE has been truly successful until central banks have exited from it, as much as they want to at least. And the very prospect of reversing QE has been a huge worry for markets for most of its existence. After all, if it has been instrumental in bailing out economies and supporting markets, would it not be reasonable to expect a pretty severe adverse reaction when QE is withdrawn ? The very suggestion of the idea of withdrawing stimulus by then Fed Chairman Ben Bernanke in 2013 provoked the infamous "Taper Tantrum", a massive and very costly spike in bond yields (and fall in bond prices).
The central banks in question are at different stages of the cycle when it comes to QE. The Bank of Japan (where per capita QE is largest and has incorporated vast purchases of equities alongside bonds) has dropped a couple of the gentlest hints that monetary easing may be coming towards an end, but a reversal of its QE programme must still be a long way off. The ECB is due to terminate its bond buying in December, but has not put a date on when it intends to start reducing its balance sheet. The Bank of England, which like other central banks will start the process of unwinding by NOT re-investing the proceeds of maturing bonds rather than active selling, will not begin until rates have climbed to 1.5% (currently at 0.75%). But it's the States and the Federal Reserve that lead the way, having already started to reduce the balance sheet. It's early days of course, but judging by the market reaction it seems barely anyone has noticed.
Fed buying of long bonds has been one of the prime reasons put forward behind yields remaining so low. At a touch over 3.00% on the 10yr, historically speaking yields remain extremely low despite the start of QE reversal (and bond gurus repeatedly calling for much higher levels). If the US is anything to go by, unwinding of Quantitative Easing does not necessarily mean a spike in yields, or for that matter a sharp steepening of the yield curve.
Gertjan Vlieghe of the Bank of England is of the opinion that much of the flattening of the yield curve in recent years can be put down to central banks being able to contain inflation much better than they were able to years ago. If there's less danger of high inflation in the future, then there's less need of higher rates of return at the longer end, which of course means a flatter yield curve. His point is that whilst it would be unreasonable to expect absolutely NO effects from unwinding QE, equally there is no need to expect damaging spikes in long-term yields and sharp steepening of the yield curve.
Well, that's a relief .... but it would pay to remember that, notwithstanding the equanimity being shown by the US Treasury market, these are very early days and there are other things that might move rates other than lifting QE.