FT - Effect of large-scale asset purchases are hard topredict

Fcommentary on current elevated tail-risk in global asset prices.

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By Alastair Thomas
June 30, 2013

Interest rates are largely driven by monetary policies and expectations of how these may evolve. Several large central banks have entered unconventional monetary policies in the last few years, most notably the US Federal Reserve, the Bank of England and the Bank of Japan.

One of the main forms of unconventional monetary policy has been asset purchases. Early announcements of asset purchases in advanced economies lifted prices globally, as they decreased the tail risk of a severe recession, but their effects diminished once markets normalised. These policies have no doubt promoted the economic recovery and reduced the risk of deflation – and helped reduce long-term bond yields in the process.

However, the benefits of large-scale asset purchases and persistently low rates need to be weighed against the potential costs, such as excessive risk-taking, the distortion of the sovereign debt and credit markets, and the impact on market functioning. If purchases are perceived to be monetising debt then there is a risk of adverse effects on interest rates and the real economy. Furthermore, purchases can delay fiscal, structural and financial sector reforms and lead to distortions in exchange rates.

The dilemma that central banks face is when such monetary stimulus should be reduced. They need to determine whether any economic growth is part of a sustainable recovery or if it is only temporary. In the case of the former, then they should reduce such stimulus. If not, then it may be best to wait, but that can result in greater risks of increased inflation expectations.

Many of the reasons why the US Fed announced additional purchases (or quantitative easing) late last year have not materialised: a weakening labour market, risks from Europe (mitigated by the European Central Bank’s “outright monetary transactions” programme announced last summer) and the fiscal cliff. Some investors and central bankers are now starting to be concerned about “financial stability”, as all asset prices move higher rather than just those that have a direct impact on the consumer’s balance sheet.

The US economy is undeniably slowly picking up and some of the main metrics that the Fed considers are probably close to target for making changes to monetary policy. Non-farm payroll increases have been good but others are still of concern. The headline unemployment rate is still high, the hiring rate is still too low, wage growth is not strong enough, labour market participation is low and there have been other mixed economic data.

The low inflation prints may assist in the prolonging of QE, although the Fed believes this state to be transitory.

However, the key to the decision to taper QE will be based not on the most recent economic data, but the Fed’s forecasts for these data.

The Fed still seems fairly confident that the recovery will pick up in the second half of the year. If it gets enough data to support this view then we could see tapering as soon as the autumn, even if rate hikes will not follow for quite some time after the asset purchases have finally ceased.

However, the exit process may prove challenging. There is a risk of much higher interest rate volatility and an overshoot in the adjustment of longer-term rates.

Large rate moves when purchases are reduced could undermine the recovery and cause big changes in capital flows and exchange rates and put pressure on government finances. The International Monetary Fund’s research paper on unconventional monetary policy states that “central banks in advanced economies should in principle be able to limit the risk of a sharp increase in long-term rates. Enhanced forward guidance and improved communication could help guide expectations of future policy rates.”

The general move to higher long-term rates as QE is reduced may also be countered by lower net Treasury issuance as the budget deficit reduces on higher tax receipts as the economy improves. Also, the impact of the Bank of Japan’s $850bn a year of asset purchases may help drive down real yields in Japan (as inflation expectations increase) forcing Japanese investors to seek yield elsewhere, including in US equities and Treasuries.

In conclusion, investors should monitor economic data carefully and be prepared for longer-term rates to move higher. Ten-year US yields of 3 or 4 per cent will seem low in a historic context, even if considerably higher than the current level. As the IMF states in the conclusion of its paper on unconventional monetary policies “the path ahead will be challenging, with many unknowns”.

Alastair Thomas is head of rates and treasury management at ECM Asset Management