QE understanding is lacking


Chris Rands

The market’s current understanding of QE on supply and demand dynamics does not capture the true economic effects, says Chris Rands from Nikko AM.

While the introduction of quantitative easing (QE) following the global financial crisis was an experiment in monetary policy, with no-one quite sure how it would play out, the unwinding of QE is set to follow the same path, he says.

“As we enter a period where QE is starting to be unwound, we have seen the expectations of how this will unfold completely miss the mark,” Mr Rands said.

“Indeed, when it comes to interest rates, quantitative tightening is having the opposite effect to what was predicted.”

Mr Rands says the typical forecast for interest rates when central banks end quantitative easing (QE) is that bond yields should rise.

“The market’s understanding of QE has typically been about demand and supply dynamics. This argument states that when QE is introduced, bond yields will rally as there is a new source of demand, and when QE ends bond yields will sell off as a large buyer exits the market.

“In theory this argument makes complete sense; however the results of QE ending in the US in 2014 and in Europe in 2018 show bond yields doing the exact opposite. In both cases, despite continued calls for rates to move considerably higher, bond yields fell over 100 basis points.

“While the timing could simply be thought of as ‘curious’ in 2014, the second occurrence in 2018 starts to raise the idea that the market’s current understanding of QE on supply and demand dynamics does not capture the true economic effects.”

Mr Rands points out that in addition to interest rates falling, there is also a relationship between QE ending in offshore markets and the Reserve Bank of Australia (RBA) making cash rate moves.

“In both 2014 and 2018 market economists were beginning to expect that the cash rate would rise, as the global economy reached “escape velocity”. However, not only did this not occur, cash rates quickly fell.”

He says that when considering the central banker’s actions over 2014 and 2018, there are two possible conclusions.

“Either the central banks simply had unlucky timing — ending QE just as the economy was about to slow.  Or else we don’t yet understand how QE works and ending it does more harm to economic conditions than we give credit.

“Given the consistency in the changes to global export volumes and the consistent decline in bond yields, it is becoming far more likely that we should believe conclusion number two, that we don’t quite understand the true effects of QE, rather than conclusion number one — that central banks have been the victim of unlucky timing.

“If true, this means investors need to think longer about how unconventional monetary policy can affect asset prices, as the bond environment shows that just expecting yields to go higher because there will be more sellers can be incorrect.

“Furthermore we can also look at the implications for the RBA’s current path of monetary policy. Should both the Federal Reserve Bank in the US and European Central Bank cut interest rates and resume QE, then there is a chance that the global economic environment shows signs of improvement after a soft six months.

“If this were to occur then the RBA doesn’t need to provide as much stimulus as the market currently expects with some of the heavy lifting coming through offshore economies. This would cause the Australian bond rally to lose its momentum, as the market is currently expecting very easy monetary policy with continued cash rate cuts and the potential for Australian QE.

“The market has spent the past three months racing to forecast the lowest Australian cash rates, focusing on the RBA’s changed employment assumptions. However, it looks like the real catalyst came from offshore in the form of changed monetary conditions.

“For investors, the takeaway is that they will need to think longer about the second and third order effects of QE programs, as changing them seems to cause unintended consequences in economic performance, which are far more complex than the simple notion that there will be more sellers than buyers,” says Mr Rands.

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