The fact is that the purchase of assets in the QE programme undertaken by the G4 central banks – the Bank of England, Bank of Japan, Federal Reserve and European Central Bank – has caused their asset holdings to jump from 8 per cent to 15 per cent since 2013, see Chart 1.
However it is evident that QE has had a limited impact on the real economy as job creation and gross domestic product (Chart 2) struggled to accelerate. This suggests that in essence wealth effects have been the main impact on the real economy which has led to increased income inequality in the economy since 2008.
In June Ben Bernanke, chairman of the Fed, said economic and job market improvement could lead to a gradual tapering down of the bond purchases later this year. He then stated it was Fed policy to enact tapering later in the year.
In response to these comments 10-year US Treasury bond yields rose to a high of 3 per cent in September 2013. However the Fed then surprised everyone by not tapering in September, with suggestions that the pending government shutdown was a major factor in the decision. Subsequent quotes from Fed members were illuminating regarding their view of the impact of QE on the economy. Here are some examples:
Narayana Kocherlakota: “Reducing the flow of purchases in the near term would be a drag on the already slow rate of progress of the economy toward the committee’s goals.”
Eric Rosengren: “I think one of the considerations we have to have is how sustainable the improvement in labour markets is. And that partly depends on how fast our economy’s growing. … We need to see growth much closer to 3 per cent than 2 per cent.”
Dennis Lockhart: “We are far from our mandated statutory goals. The economy remains weak.”
James Bullard: “I would like to see inflation coming back toward target before we make a decision to taper.
Charles Plosser: “We missed an excellent opportunity to begin this tapering process in September. This illustrates just how difficult it is going to be to wean ourselves off the extraordinary process of increasing accommodation we have embarked upon and begin to normalise monetary policy in a timely manner.”
The battle between the doves and the hawks is clear. It was seen as a missed opportunity for the hawks who had spent much time in preparing the markets for tapering. They would argue that QE was part of the problem, crowding out private investment by preventing the uncompetitive companies from facing up to their inefficiencies.
Meanwhile the doves suggested that without QE there would be reduced activity in the economy, and that at present the economy was still very weak on unemployment and output readings. They also argue that without inflation pressures there was little to fear by keeping the proverbial printing presses going. They also suggested that the efficacy of QE was failing with the surprise factor being eroded with each subsequent QE programme.
The yield curve tells us many things. The near-term – up to two years – reflects the solvency of the country and the expectations from the central bank regarding overnight rates. The solvency issue was seen recently with Greece where the credit moves to solvency concerns and the curve becomes inverted, suggesting the near-term risks were greater than longer term ones.
The belly of the curve – two to 10 years – relates to growth expectations. The five-year forward is the part of the curve that the Fed likes to take notice of as it best reflects the expectations of real growth that includes both the nominal rate of growth and inflation. The issue facing the US has been of negative implied growth rates with sticky inflation and the pinning of rates in order to make the cost of carry of cash negative.
Liabilities
The longer end of the curve – 10 to 30 years – relates to a normalised view of the economy that is needed to reflect the rates offered to pension funds and mortgage holders who fix their long-term liabilities. This part of the curve is rather passive in the sense that the spread on the belly of the curve tends to be rather stable in a normal environment when there are no central bank programmes on which to pin the 10-year rates.
Therefore the key determinants for the 10-year point (as that is the focus of the QE programme) are growth, inflation and uncertainty or steepness of the curve, which can be calculated through the US Treasury term premia. We can examine how QE has impacted this particular measure.
How has QE impacted rates? There is no doubt that rates have been pinned through the programme of US Treasury bond buying. The series of QE programmes has kept a lid on the 10-year treasury premium. The points of QE introduction led to a near-term 150bps rally in 2009, 100bps in 2010 and little change in 2012. This is the diminishing effect of QE as pointed out earlier, although QE3 was a more nuanced programme that included specific mortgage-backed securities purchases in order to keep the credit spread on mortgage loans at a minimum.
In essence it can be seen that QE has dampened premia, although it should be stressed that the impact has been diminishing through laws of marginal utility, growth expectations normalising and general QE fatigue. The only surprising element is the fact that inflation expectations have remained benign.
If the only determinant was whether the Fed was going to taper or not then it would seem that the action to taper would lead to a rise in yields in the short term as evidenced by the move going into September’s Fed meeting. However the story is more complicated than this. A normalisation of rates may be desired but tapering is the first step. The need to normalise will only emerge once inflation expectations rise and the real economy gains traction from the private sector. The lack of follow-through on jobs, earnings and productivity reflects the overhang of weak demand and it seems that confidence remains susceptible.
We have observed how significant a driver QE is on risk markets, and from this one can suggest that there are risks from stopping balance sheet expansion too quickly.
Therefore while inflation expectations remain benign, the likelihood is that the impact of tapering will be limited on longer-term rates. The key, as has been suggested by the doves, is for the real economy to be impacted for QE withdrawal to impact rates in a meaningful way.
This was confirmed by Janet Yellen, the vice-chairman of the Fed and President Obama’s nominee to become the next chairman in January, who said: “The economy is performing far short of its potential. For these reasons the Fed is using its monetary policy tools to promote a more robust recovery. A strong recovery will ultimately enable the Fed to reduce its monetary accommodation.”
In terms of an income fund looking at maximising returns, one then needs to consider the yield received alongside the capital gains/losses on the bond. If one estimates that tapering will raise rates but not in a meaningful way until we have real growth then the ideal time to get into income funds would be on the first tapering act.
This would indicate picking up the immediate rise on 10-year yields (maybe 3.25 per cent to 3.5 per cent) but then play into capital gains as the underlying rates remain pinned for longer than anticipated.
Chetun Patel is head of strategy of Mariana Capital
Key Points
The purchase of assets in the QE programme undertaken by the G4 central banks has led their asset holdings to jump up from 8 per cent to 15 per cent since 2013.
The decision not to taper was seen as a missed opportunity for the hawks who had spent much time in preparing the markets for tapering.
For bond investments one needs to consider the yield received alongside the capital gains/losses.
