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Monday, 23 October 2017

Soft landing

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  • End of QE2 already priced in todays' market

Debates still rage about whether quantitative easing achieved its goals, and whether politicians got the size of the capital injection right. But with the end in sight, bond markets are now preparing for life after QE, with most unfazed by the prospect. David Rothnie reports.

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According to the poet T.S. Eliot, April is the cruellest month. The US bond market may have a different view, having breezed through the month despite two events that were expected to send yields soaring.

First, the decision by Standard & Poor’s to place the US economy on negative outlook barely made a dent on Treasury prices. Similarly, the announcement last month by US Federal Reserve chief Ben Bernanke that the central bank will end quantitative easing in June failed to create any waves in the bond markets.

“There is clear evidence that the bond markets have front-run the start of quantitative easing and they will front-run the end of it,” said Steve Major, head of global fixed income strategy at HSBC.

Major said in a note to clients last month: “Just as the biggest impact on level of yields has been in preparation for QE, the delivery of the promised purchase of bonds has coincided with a rising yield trend.”

This view is supported by a sharp fall in US ten year yields to 2.4% in August last year in the run-up to the announcement of a second round of quantitative easing by the Fed in November. From August onwards, yields started to rise again.

Where it all began

The original point of the Federal Reserve’s US$1.2trn bond-buying programme, introduced in December 2008, was to prop up the housing market with the purchase of mortgage-backed securities. It was not until QE2 that treasuries were targeted specifically. According to terms of the programme, the Fed bought up US$600bn on government bonds in a round of purchases running between November 2010 and June 2011.

Beyond the fact that QE2 raised inflation expectations, analysts are divided about its value. “QE in itself does not necessarily lead the banks to lend more money,” said Francis Yared, head of European rates strategy at Deutsche Bank. “While it will increase the monetary base, this does not need to imply strong growth in monetary aggregates or increased velocity.”

“According to the Fed’s own study, there is a 7bp decline in yield for every $100bn of cash invested by the Federal Reserve, but that does not take into account other factors that might drive spreads,” said Alessandro Tentori, interest rate strategist at BNP Paribas. “So it’s very limited in terms of the absolute level of yield.”

This is partly due to the size of the programme relative to the overall size of the market. By this yardstick, analysts argue that the UK’s QE programme was far more effective. The Bank of England purchased £250bn of gilts, which amounted to 34% of the total gilt market. By contrast, the Fed’s US$2.4trn programme was equal to only 12% of the US Treasuries market. “We would argue that the UK gilts programme was far more effective,” said Tentori. “The BOE holds 34% of the gilt market, three times the relative size of the FED’s QE portfolio.”

Intervention by European governments is even less significant from a sovereign perspective. “While the covered bond buying programme was a huge success, the European central bank’s government bond programme accounted for only 3.4% of the market, reflecting its reluctance to embark on QE,” said Tentori.

Reasons to be fearful

Despite the argument that QE2 was too small in relative terms for its cessation to have a dramatic impact on Treasuries, plenty of reasons to be fearful about the end of QE2 have been sighted by various market participants. Bill Gross, co-chief investment officer of Pimco, the world’s biggest bond fund, raised the alarm bells in April when he revealed Pimco had dumped all its fund’s US-govenrment-related debt holdings in anticipation of the end of QE2. In his quarterly commentary on the markets, he pointed to the fact that the Fed accounted for 70% of purchases of US bonds. His central assertion was that the sudden disappearance of this buyer group would create a huge overhang of sellers.

Some analysts said that Gross was an interested party and his current position could change in future. Others disagreed with the notion of a buyers’ strike following the end of QE2. “The bond market is more complex than the usual laws of supply and demand,” said Major. “There is evidence to show that the Fed’s buying of Treasuries stole demand from other central banks and that when the Fed steps back, those central banks will return with a vengeance.”

A broader fear is the impact that the ending of QE2 will have on the global economic recovery. “There is no evidence to support the much-held claim that sellers of Treasuries to the Fed re-invested the proceeds in riskier assets, particularly in emerging markets,” said Major.

The apparent inability of the Fed’s QE programme to affect US treasury yields is linked to the asset class itself.  Treasuries are alone among sovereigns in being a genuinely global asset class, giving investors few alternatives to switch to in their portfolios. Also, the dollars status as the world’s reserve currency provides support for Treasuries. “A downgrade for Greece pushes yields north of 20% while a similar action in the US leads to lower yields. This is because Treasuries are still seen as a safe haven,” said one analyst.

QE is dead, long live QE

While Bernanke may have called time on QE last month, he fell short of realising the worst fears of investors and signaling the start of tightening monetary policy.  Rather, he stressed that he could not say when the Fed would start to tighten monetary policy. This was proved by the fact that the Fed will not be shrinking its balance sheet following the end of QE2 by redeeming maturing bonds. The Fed will reinvest money from maturing bonds, Bernanke said, thereby continuing the cheap money policy.  In other words, direct QE is being replaced by QE-lite.

Bernanke’s announcement last week that QE2 will end in June rules out a further round of easing in the short-term. Many reasons have been suggested for this. Firstly, QE2 is perceived to have done its job of raising inflation expectations.  Secondly, the US government’s apparent desire to finally embrace austerity has erected a political barrier to further easing.

Thirdly, the Fed does not have the power it enjoyed in 2008, when it first stepped in to by up mortgage bonds to arrest the slump in the housing market. “The Fed invoked special powers back in 2008 that it no longer has. One of the many side-effects of the Dodd-Frank legislation means that the Fed will have to secure special permission from the FDIC if it wants to introduce QE3,” said Major.

Rather than taking their cue from the central bank, the US bond markets regard surging inflation as the most important factor weighing on rates. “Forwards are pricing a 25 basis points increase in 10 year Treasury yield over the next 6-months, partially factoring the end of QE,” said Yared.

Yared argues that the resilience of US Treasuries  suggests that the market is giving the benefit of the doubt for the US to get its fiscal house in order, although some risk premium is starting to emerge in the currency market. In a note in April, he wrote: “Of course, the US benefits from the ‘exorbitant privilege’ of being a reserve currency. But this privilege is  if anything likely to be reduced over time, as key emerging market countries such as China, rebalance their economy towards internal consumption and accept a faster adjustment to  their currency to counteract inflationary pressures. In fact, and as we argued in the annual outlook and in last week’s Bond Market Strategy, despite some adjustment  to the US dollar, the current twin deficits position of the US is  still not reflected in the level of US treasuries and the US dollar.”

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