Quantitative easing (QE) has been one of the most influential themes financial markets have seen in the years since the financial crisis. Today, the first of the big four central banks is gearing up to begin reversing that process.
It should be fairly simple to figure out what that could mean for financial markets. Just take the playbook of the last several years, and turn it upside down.
That would mean interest rates heading back toward more normal levels, currencies of countries who embarked on QE rebounding, and some of the heat coming out of asset prices.
I’m sure it won’t be quite that simple, but that’s the basic premise. QE held interest rates artificially low, had a negative impact on the likes of the US dollar and the euro, and bumped up the value of just about every asset that could be invested in.
The Federal Reserve in the US will be the first to move, while their counterparts in Europe and the UK likely won’t be too far behind. They’ll watch with interest and see how things go for the Fed, before following a similar path. Japan is a slightly different kettle of fish, so will be in no rush.
QE is one of two main tools central banks have at their disposal to tighten or loosen monetary policy. Most of us are familiar with the other, which is moving short-term interest rates up and down. Here in New Zealand, that’s where the OCR comes in.
QE is much harder to explain in just a few sentences. It’s when a central bank increases the size of its balance sheet by purchasing assets like government bonds and other securities. It buys these from the private sector, and pays for them by creating reserves.
This increases the size of its balance sheet, with the bonds on one side of the ledger and a higher level of reserves on the other.
This eases financial conditions by reducing interest rates right across the spectrum and also throwing out the market equilibrium, forcing the private sector players to replace those securities with something else.
The main way for the Fed to reverse this is to simply wait for some of those government bonds to mature, and instead of reinvesting the proceeds to buy new ones, doing nothing.
The government still needs the money, so it will still issue new bonds, but someone else in the market will have to buy them this time around. If a commercial bank does, the reserves they have at the Fed will go down as they pay for their new bonds.
That causes the Fed balance sheet to shrink a little, as the government bonds aren’t sitting in the assets column, and the corresponding amount of reserves have gone from the other side too. Make perfect sense?
Didn’t think so, but the key point is that the central bank actions of the last several years are about to start moving in reverse.
We don’t need to panic. This process will be very slow and gradual, and will take years, rather than months. The Fed appreciates this is somewhat uncharted territory, and will want to tread carefully.
However, we should expect a steady move higher in global interest rates, a change in currency market dynamics, and a few more headwinds for many other asset classes.
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This article was published in the New Zealand Herald on Wednesday 27 September 2017 under the title “Mark Lister: Reversal of QE but no need to panic” .
Mark Lister is Head of Private Wealth Research at Craigs Investment Partners, his Adviser Disclosure Statement is available on request and free of charge under his profile on craigsip.com. For personalised investment advice please contact a Craigs Investment Partners Investment Adviser or phone 0800 272 442. This column is general in nature and should not be regarded as specific investment advice.
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