Curmi & Partners

Exiting QE

Article by Matthias Busuttil

Four weeks ago I wrote an article about the economic advancements in the Euro area and what is likely to be the policy response of the monetary authority – the European Central Bank (ECB). While we are still far from moving towards a tightening policy, the topic of normalisation in monetary policy across the major central banks is gaining a lot of focus, especially when considering the sizeable effects that such policies have had on financial markets over the last few years.

To appreciate the current situation, it is important to understand the context within which central banks are taking such actions.

Following the aftermath of the 2008 sub-prime crisis, monetary authorities delved into an unprecedented level of monetary easing. Besides using conventional measures to stir short term interest rates, major central banks, including the ECB, the US Federal Reserve, the Swiss National Bank and the Bank of England, resorted to non-standard measures in the form of monetary injection programs, broadly referred to as quantitative easing (QE). The purpose of such programs is to lower long-term interest rates and increasing money supply with the objective of stimulating growth and restore inflation back to its target level.

Although different modalities were adopted by the various central banks, the final effect is broadly the same – a systematic and considerable increase in the size of their balance sheet. While many academics wrote about the benefits and drawbacks of QE, the winding down of such programs has been little, if at all, studied. The main question now is what will happen once the economy approaches full employment and inflation is restored. Clearly, central banks would not be in a position to maintain the current size of money supply without overheating the economy.

The US Federal Reserve has been the first to indicate a break off from the peloton and will probably be the first to test ways of contracting its balance sheet. Aside from the path of rate hikes currently underway in the US, the Federal Open Market Committee has indicated at its last meeting that it will be laying out plans on how to reduce the amount of securities bought under its QE program.

Financial markets were surprisingly very little affected by the renewed determination of the Fed to tighten monetary conditions. US 10-year treasury yields actually traded lower, credit spreads and the VIX volatility index remained low and stable while equity markets experienced a small correction to the downside. Moreover, the market-implied probability of another rate hike this year was of less than 50% despite the reaffirmation by Fed to raise rates one more time in 2017.

The divergence that is developing between Fed guidance and market expectations could potentially relate to the interplay of two major factors.

The first is the evident shift by the Fed from being less dependent on economic data to focusing more on the normalisation of monetary conditions. The priority of the Fed seems to be to revert back to a normal monetary regime where it can stimulate or tighten conditions depending on the economic cycle preferably by using conventional measures. Through normalisation, the Fed would effectively be restoring its ability to deal with possible economic turmoil again in the future.

The indirect effect of this shift is the pressure exerted on the market to neutralise the high degree of complacency and excessive risk taking by participants which developed over the past few years of monetary support. These are the so-called side effects of QE. 

The second potential cause of divergence is the lack of conviction on the economic growth path by market participants. Markets had reacted strongly to Donald Trump’s stance on tax reforms and infrastructural spending when he was elected. However, there are increasing doubts on whether he will be able to deliver on such policies, not to mention the possible impeachment following allegations of obstruction of justice. 

Markets are starting to anticipate growth and inflation to undershoot over the next few years. Consequently, this could force the Fed to backtrack on its tightening agenda and potentially loosen monetary conditions once again.

In any case, any effort towards reversing the injection of money by central banks will probably be very slow and gradual. It is yet unclear what the absorption effects will be both on markets and financing conditions in general. Investors should pay close attention to the evolving reaction function of central banks, especially in view of a pending disappointment by the market when participants eventually realise that monetary support is gone.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.