Sunday, 23 September 2018

Caution: no exit

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Quantitative easing may have stopped, but arguably the greater challenge – unwinding it without undoing all the good of the original measure – will be a perilous balancing act.  Debates rage on over the right timing and strategy for an exit, but no details are likely to be provided until governments have provided clear and satisfactory details regarding how they plan to reduce their debt levels. David Rothnie reports.

When central banks in the US and the UK began pumping new money into the banking system and buying up government bonds, in order to unblock the credit markets in the latter part of 2008 and early 2009, it begged two big questions. Will it work? And how will it be unwound?

The first question has been answered. Quantitative easing has encouraged banks to start lending to clients again, rather than simply borrowing at low-to-no interest and investing it in government bonds – though the cost at which banks are prepared to lend to companies remains high.

It has also saddled national governments with massive levels of debt – levels that were already high following bank bailouts and more traditional public expenditure. QE was introduced after interest rates in the UK and US were slashed to almost zero and failed to stimulate the credit markets. After pumping billions of extra money, last year US and UK central banks stopped buying bonds. But central banks are now sitting on their hands before instigating the sale of securities.

“You are talking about two distinct phases,” said Laurence Mutkin, head of European interest rate strategy at Morgan Stanley. “One is stopping QE and other is reversing it. The first has happened, but we see no evidence of central banks selling off securities and no need for them to do so before they tighten rates. It could happen, but we think it is a very long way off.”

Deciding when to reverse QE is a big challenge for central banks. The only precedent for the measure was in Japan, which critics say mismanaged the process by waiting too long to start QE, before tightening monetary policy too quickly.

Beware the inflation genie

There are a number of factors to consider. Both the UK and US are heavily indebted and the removal of QE has further cheapened sovereign bonds. This is an argument against reversing QE. At the same time, the economy is recovering and central bankers want to avoid what Mervyn King, the governor of the Bank of England, has called “sowing the seeds of the next crisis” by keeping interest rates artificially low.

This month, the UK’s Office of National Statistics showed a sharper-than-expected rise in UK inflation. The Consumer prices index rose by 3.4% in the year to March, up from 3.0% in February. The retail prices index, which also takes account of housing costs, rose by 4.4%, up from 3.7%, pushing it up to an 18-month high. “No central banker wants to stand accused to creating the next credit bubble by keeping interest rates too low for too long,” said Moyeen Islam, a director in fixed income strategy at Barclays Capital.

The removal of QE, with governments no longer acting as buyers of sovereign bonds, along with record deficits and events like the Greek sovereign crisis, conspired to ramp up yields demanded by bond investors to take sovereign debt.

“We are talking about withdrawing excess liquidity,” said Islam. “Since the cessation of QE there has been a substantial cheapening of government debt to other kinds of debt, as supply has continued to be heavy but central banks have disappeared as a buying source.”

As national deficits have risen, investors have demanded more yield in exchange for what Mutkin calls “renting balance sheet.” In a recent report he wrote:  “The premium that borrowers have to pay to obtain the use of capital – even for quite short periods, and certainly for long terms – has jumped from what it was before the start of the financial crisis in July 2007.”

During the credit boom, the cost paid by governments to ‘rent’ balance sheets was at times negative. Since then it has undergone dramatic re-pricing, said Mutkin: before July 2007, government bond yields were lower than same-maturity swap rates across the yield curve and across currencies. That indicated investors would rent balance sheet to governments for any term at pretty much the same margin relative to the expected future path of money-market rates. Since the financial markets crisis, long-maturity government bonds have cheapened so that they now yield more than swaps.

Last month, the 10-year US swap spread turned negative for the first time on record, amid rising demand for higher-yielding assets such as corporate and emerging market securities. The gap between the rate to exchange floating- for fixed- interest payments and comparable maturity Treasury yields for 10 years, known as the swap spread, narrowed to as low as negative 2.5 basis points at the of March. The decline of US interest rate swap spreads to the lowest levels on record reflects a shift in investor focus from the plight of financial institutions to the ability of nations to finance rising fiscal deficits. Sovereign debt worries had replaced the banking crisis as the main concern for investors.

Both the UK and the US have been warned by credit rating agencies that their credit ratings might be in jeopardy if they don’t address their record budget deficits. A downgrade would trigger a sell-off in Treasuries and gilts. In other words, there is no incentive for governments to start selling bonds.

“The Bank of England has been far more aggressive in the actual purchase of securities relative to GDP,” said Islam. “The MPC blithely said sell the gilts back at some stage. That makes sense because you do the reverse of what you did. But the consequences are harder to understand. If you want to tighten monetary policy by sending rates higher, why not just do that. Raising interest rates will send yields higher so there is no sense in selling gilts.”

The Bank of England has conceded that it will not unwind QE ahead of any rate rise, but it has provided no details regarding a possible exit plan. The publication of the minutes of the MPC April meeting revealed a unanimous decision to keep rates and the amount of QE unchanged (at 0.5% and £200bn respectively). Analysts expect the Federal Reserve and the Bank of England to increase interest rates during the third quarter, and possibly earlier (Barclays Capital credit analysts predict an August tightening, while Deutsche Bank’s team points to November). The European Central Bank is likely to follow suit early in 2011. 

Mum’s the word

“We are hanging on the monthly minutes of the Monetary policy committee,” said Islam. “But it’s unlikely that the Bank of England will raise rates and sell back an unknown amount of gilts through a process unknown and timing unknown.”

There is also little sign of any let-up in the supply of government debt. Fears of contagion from the Greek crisis can only act as further disincentives to reverse QE. In a report published last month Standard & Poor’s said governments across Europe need to raise €1,446bn (£1,313bn) this year as the full damage inflicted by the credit collapse – masked last year by emergency stimulus measures – becomes ever clearer.

This will become harder to fund cheaply as central banks start to tighten. “We believe that benchmark yields have benefited from liquidity injections into the financial sector and QE measures by the Bank of England and the Federal Reserve,” the report said. “As that support could eventually be withdrawn from 2010, excess supply in government bond markets could start driving benchmark yields back up. Such a development, in combination with potential further increases in spreads in line with country-specific risks, could eventually add to fiscal pressure in a number of sovereigns with high deficits.”

Central banks are unlikely to contemplate any reversal of QE until markets are convinced about the sustainability and credibility of government debt reduction programmes. “Markets look favourably on clear plans to deal with debt,” said Islam. “The Irish put out a fairly swingeing reduction programmes that were well received and the issue is now being properly addressed in the run-up to the UK general election.”

Morgan Stanley believes the rise in borrowing costs for sovereigns is a “secular”, rather than a cyclical change. The report concluded: “The change in cost of rent of balance sheet is a secular, not cyclical, event. So its effect on financial markets will be long-lasting. Do not expect recent market movements to reverse any time soon.”

A credit strategy update published in April by Deutsche Bank warned: “The worst case scenario is that a run on Government bonds forces politicians to loosen their support for sectors like financials. If the market forces cut-backs on an administration at a time of crisis, some banks which have government capital bolstering their balance sheets may be much more vulnerable, thus risking financial market stability again. For a period of time, this would likely lead to wider swap and credit spreads across the board. Clearly this would only happen if there was literally no other alternative. While Governments have a choice, they will likely ‘spend and bail’ to protect their economy rather than destabilise the banking system and with it the economy.” 

While investors hunt for better yields from corporate and junk issuers, bankers say it is hard to envisage the right time to exit from QE. It will be difficult to avoid a sell-off when it comes.

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