The US Federal Reserve quantitative easing (QE) programmes and similar programmes implemented in other countries, most recently Japan, continue to force down yields through massive purchases of government bonds and other selected fixed-income securities.
Exceptionally low interest rates due to QE have undoubtedly helped the US and global economies recover from the so-called “Great Recession” triggered by the 2008 credit crisis.
But artificially low interest rates, by definition, distort economic decision-making. If maintained for too long, these ‘artificially’ driven decisions may lead to material distortions in the global economy.
A good illustration of this is the evolution of yields on high-yield bonds. Record suggests the yield on these US BB-rated bonds would probably be higher in the absence of pressure from QE. Moreover, it is likely that demand for, and the prices of, other assets that generate above-average yields may well be inflated by pressure from investors who would normally invest in higher-quality government securities.
A second important asset class that may be ‘artificially’ inflated by QE is equity. Here, artificially low discount rates, driven by QE-depressed government bond yields, boost the attractiveness of equity earnings streams.
Evidence that QE programmes can influence equity market prices can be seen in the sharp rise in Japanese equities after it became clear that Japan’s new prime minister Shinzo Abe would pave the way for a highly aggressive QE programme.
More evidence that QE is important to equities is the setback in US equity prices that occurred after the January Federal Reserve minutes suggested QE could end early. The decline in the US and global markets (as measured by MSCI World index) that coincided with the February 20 release of the minutes halted only after the chairman of the Federal Reserve, Ben Bernanke, indicated strongly that he intended to continue QE.
It appears QE probably creates significant economic distortions, such as pushing up the prices of high-yielding assets and probably fuelling equity price rises in affected markets. If QE works too well – that is, the economic recovery in markets is too strong – then this will augur an earlier than expected end to QE.
Far from being good news for the markets, however, an early end to QE may lead to higher volatility as the distortions that may have been caused by QE unwind. Ironically, investors may find that equity markets will do best if economic growth is slow and that volatility may rise if the economic outlook looks too strong.
Andrew Harmstone is managing director at Morgan Stanley Investment Management
