Central banks are tightening monetary policy because the global economy is strengthening.
So we should not necessarily fear either interest rate or balance sheet normalisation.
However, quantitative tightening is likely to result in higher volatility. And companies, or governments, who have taken on too much leverage in the period of low interest rates, are likely to be left exposed.
In 2008, confronted with the worst financial crisis since the 1930s, the US Federal Reserve decided to deploy an unconventional monetary tool: quantitative easing.
In the years that followed, central banks in the UK, Switzerland and eventually the eurozone all took similar measures, contributing to total monetary stimulus (including purchases by the Bank of Japan) to the global economy and its financial markets that has now reached $16tn (£12.5tn).
QE was designed to encourage investors to search for yield. By increasing demand for riskier assets such as corporate bonds, this lowered borrowing costs when the economy – and tax receipts and profits – were weak.
We estimate QE programmes lowered the US government’s 10-year borrowing costs by approximately 100 basis points. Lower risk-free rates led to lower discount rates, which partially helped equity markets and encouraged investors to look further out on the risk and maturity spectrum to obtain extra yield.
- We are entering a period of monetary tightening as the global economy is strengthening
- Other central banks may follow the Fed's move of raising interest rates in December 2015
- Investors may wish to consider focusing on sectors and styles that are positively correlated with higher interest rates
QE calms waters
QE served to compress yields, but most likely also suppressed volatility.
The European sovereign market is a clear example of this. When the European Central Bank was an active buyer in European sovereign bond markets, investors were to a large degree insulated from political noise.
In contrast, the election of a new populist government in Italy coincided with the tapering of the ECB’s QE programme, resulting in considerable volatility in the Italian bond market this year. In short, central banks are no longer actively ‘buying the dips’.
Given that the economy is now normalising, it is perfectly sensible for central banks to begin the process of normalising both interest rates and balance sheets, or quantitative tightening. Furthermore, the process is expected to be very gradual.
The Fed started to raise interest rates in December 2015, and it has not led to meaningfully higher interest rates, nor a significant tightening of financial conditions in the US economy.
The Fed has benefited from a first-mover advantage, but as inflation and growth normalise elsewhere, other central banks may follow suit – also at a very gradual pace.
The ECB has announced it will put an end to net asset purchases at the end of 2018 and that rates are not likely to increase until at least the summer of 2019.
QT will cause debt servicing costs to increase for both governments and companies, but this should coincide with higher earnings. However, the process will not be easy or seamless if too much debt was accumulated in the period of low interest rates.