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Leaders’ Perspectives – June 2017
The long
unwinding road of
quantitative easing
Mark Burgess
CIO EMEA and Global Head of Equities
nn Quantitative easing (QE) has resulted in heavily indebted developed economies
and has had varying degrees of success.
nn An unwinding of QE could cause increased volatility in the markets and a fight for
remaining liquidity, as the supply of government bonds starts to disappear.
nn QE has served its purpose of being a life raft for many of the largest economies
and now central banks must start to go back towards the norm of pre-crisis
levels, so that they have ammunition to tackle the inevitable next crisis.
The reasons for using QE and its effectiveness financial crisis, central banks in the US, UK and
have been argued at length and this article aims Europe were forced to follow suit, pumping large
not to discuss whether or not QE has worked, but amounts of money into the banking system to
to look at the likely next steps of central banks prevent it from collapsing.
and how these could impact markets.
These measures have caused an array of
QE first reared its head in Japan in 2001, when consequences (intended or otherwise) that will
the Bank of Japan (BoJ) became the first central need to be addressed sooner or later. At its core,
bank to purchase government bonds financed QE has resulted in heavily indebted developed
by the creation of central bank reserves. This economies and has had varying degrees of
happened when the BoJ found itself backed into success, which has arguably been dependent
a corner as it approached the presupposed lower on the extent of distortions or frictions in the
bound for nominal interest rates and needed functioning of various markets.1
to stimulate the economy. Following the global
1
http://www.bankofengland.co.uk/research/Documents/workingpapers/2016/swp624.pdf
8
Leaders’ Perspectives – June 2017
FIGURE 1: CENTRAL BANK BALANCE SHEET SIZE RELATIVE TO NOMINAL GDP (LHS) AND GOVERNMENT DEBT (RHS)
Dashed blue line indicates Bank of Per cent Dashed blue line indicates Bank of Per cent of gross
England projection with 100% usage of of GDP England projection with 100% usage of government debt
the Term Funding Scheme, dotted line the Term Funding Scheme, dotted line
indicates 50% usage 140% indicates 50% usage 60%
Projection Projection
120% 50%
100%
40%
80%
30%
60%
20%
40%
20% 10%
0% 0%
2006 2008 2010 2012 2014 2016 2018 2006 2008 2010 2012 2014 2016 2018
Bank of England Federal Reserve ECB Bank of Japan
Source: BoE Staff Working Paper No. 624 – QE: the story so far, Haldane et al. October 2016.
Now that we are a decade on since the start of the crisis, surely it is time to think about what happens
next to QE. Despite a fairly uniform decision to undertake QE across developed markets, the methods
used have differed and so will the approaches to unwinding in the US, UK, Europe and Japan. The
general market effects of QE have been lower discount rates, a weaker currency, and a strong
environment for risk assets. Bank of England (BoE) studies have also shown there to be strong positive
international spill-over effects of QE. Therefore, it is safe to assume that any rollback of QE would also
have international impacts in such an interconnected world.
Are central banks maintaining their independence?
Before we get into the when and how, let us governments could indebt themselves without
first consider if QE even needs to be unwound. real consequences and could lead to consistent
Arguably, if the debts held by central banks are overspending. As markets lose their faith in the
continually rolled over and the coupons on the reliability of a country’s intentions to fulfil debt
debt are not required to be paid, then does the obligations, we could see inflation shoot up and
debt really exist? the value of the country’s currency plummet. As
we all know, trust is fundamental to the efficient
The idea of simply cancelling QE debt has been functioning of markets – so which (if any) central
bandied around and, although not economically bank is brave enough to admit to taking this step?
different from central banks holding onto the
bonds and accumulating cash flows indefinitely, Consequently, could the rolling back of QE be
markets would react very differently to these considered so much of an inconvenience that
options. The budgetary implications of QE in central banks simply opt to keep it indefinitely on
the UK already correspond to a de facto debt the balance sheets? This would certainly make
cancellation, but a de jure cancellation would those central bankers, already concerned by the
impede the BoE’s ability to resterilise the bloated balance sheets, uneasy as they face the
monetary base at some point in the future. prospect of a new norm plagued by the threat of
This is something the former governor of the inflation and a lesser set of tools at their disposal
BoE, Sir Mervyn King, has highlighted but in the event of the next crisis. Or perhaps there
the BoE in particular wanted to avoid, as by will be an attempt to gradually reduce the debt
doing this it would suggest that central bank while trying to avoid another taper tantrum? Let
independence is not so independent after all. us consider the likely options central banks could
Announcing debt cancellation would indicate that take around the world.
9Leaders’ Perspectives – June 2017
US
In the US, the Federal Reserve is arguably the As the Fed continues its gradual rate hiking we
furthest along in terms of starting down the are likely to start to see a tapering of balance
path to the old status quo. The last of QE was sheet reinvestment starting in 2018, with details
completed in 2014, leaving the Fed with a portfolio emerging over the forthcoming Federal Open
of US$4.5 trillion on its balance sheet, which it Market Committee (FOMC) meetings. With the
has since maintained at this level by rolling over current shape of the portfolio on the Fed’s
the debt and reinvesting any principal. While the balance sheet, if all the debt maturing is allowed
Fed considers its stance on when the balance to roll off then there would be a sharp run off
sheet can start to be reduced we have seen small in 2018, reducing until 2024 when this flattens
rate hikes. The ‘softly softly’ approach is very out. To avoid such a large shock to markets, the
much being taken with lots of hints being passed path of the debt roll-off is much more likely to
to the markets so as not to spook them and be smoothed as is indicated in Figure 2. In this
cause an event like the taper tantrum in 2013, scenario, we would expect to see a small amount
which led to a surge in US Treasury yields. That of upward pressure at the long end of the curve of
event is precisely the reason that Federal Reserve between 15-30bps towards the end of 2018. The
Chair Janet Yellen is delaying an unwind, as the tapered approach to debt roll-off would help the
central bank wants to maintain a buffer to absorb Fed maintain some flexibility to change its mind as
economic shocks while the economy remains the markets’ reaction is observed.
seemingly fragile.
FIGURE 2: FED’S TREASURY PORTFOLIO
450 2,500
400
350 2,000
300
1,500
250
200
1,000
150
100 500
50
0 0
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2036
2037
2038
2039
2040
2041
2042
2043
2044
2045
2046
Runoff ($bn, lhs) Total holdings ($bn, rhs)
Source: RBC Capital Markets US Economics, FRB April 2017.
For now we should expect further gradual rate hikes, which may pause if the FOMC starts to normalise
the balance sheet later this year on the back of more positive economic numbers (as hinted by Dudley
in a recent speech). Markets are yet to take Dudley’s suggestion or any more drastic options seriously,
though surely at some point this will have to change – if the US does not set the trend of rolling back
QE, what hope is there for the rest of the world?
10Leaders’ Perspectives – June 2017
UK Europe
The next obvious place to follow suit in the 2017 is all about politics in Europe with the
unwinding of QE would have been the UK; numerous elections taking place. Markets have
however, studies have shown that any unwind is been suspicious after the shock votes in 2016,
currently near impossible. This is because of the but so far fears have been unfounded as the
large amount of QE banks have used to meet their populism craze seems to be going out of fashion.
prescribed regulatory buffers. Any removal of this Also, in spite of the election concerns, we are
money will leave financial institutions fighting over seeing good economic numbers coming out of
remaining liquidity to avoid falling foul of these Europe which could suggest that more QE is
regulations. The way around this is to reduce the less likely. Earlier this year Draghi stated that
amount required to be held in buffers, but it is policymakers were now confident that they had
unlikely that central banks will want to take away removed the threat of a severe bout of deflation.
that safety net. Couple this with a calmer political outlook and
we are likely to see the ECB move towards a less
It is important to note that in the UK we can see loose monetary stance.
some of the unintended consequences of QE,
which highlight the need to address the situation The first stage for Europe has been the signal
before more irrevocable damage ensues. Firstly of the end of QE-infinity before an actual halt to
the housing market has been impacted by QE − and then finally a roll-back much further
artificially low rates inflating house prices as those down the line. So far, the ECB is around 80% of
with the means to put down large deposits invest. the way through the EUR2.28 trillion QE extension
Banks insist on larger deposits as a means of which will be complete by the end of the year,
identifying individuals who will be able to continue with a complete end of QE (with the potential to
to service mortgages if interest rates increase, start tapering) as soon as the end of 2018, as
which keeps the younger generations off the the ECB is quickly running out of eligible bonds
housing ladder for longer. This is compounded to buy. The ECB is the central bank most at risk,
by the fact that rent is going up, hindering those as it owns a large proportion of government debt
same younger generations from ever being able to of the multiple member states. This puts the
save for a deposit. ECB balance sheet at risk of default if there is a
fracturing of the European Union.
At the other end of the generational scale, there
are those whose defined pensions are at risk. The
present value of long-term future-defined benefit
pension liabilities has risen to the point that they
are mismatched with the pension assets that have
been boosted less by the lower rates and higher
asset prices. These issues are starting to wear
thin with the British public, so surely something
must be done. Perhaps though, this is not yet
the time for the BoE to make its move with the
uncertainty of Brexit on the horizon. Interest rates
will most likely stay low (though small hikes could
be possible) to attract Foreign Direct Investment,
which is so vital to the UK to finance its current
account deficit. This does leave the country at
risk of having minimal tools to use if another crisis
were to take place. Maybe helicopter money or
debt write-off are the next steps? In the UK, the
equivalent of around 30% of overall debt has, from
a budgetary perspective, already been effectively
cancelled. So could it be argued that this might
not be too much of a leap for the BoE?
11Leaders’ Perspectives – June 2017
FIGURE 3: ECB QE PURCHASES BY TYPE AND COUNTRY
IMPLEMENTING QE – HOW MUCH PROGRESS? COMPOSITION AND PURCHASE VOLUMES (IN EUR BN)
2400 2280
2000 1880
79.8%
1600 79.7%
1200
800
400 260 92.5%
140 57.9%
0
Total PSPP ABS/Covered CSPP
Adjusted programme purchase volumes (estimated), in EUR bn Purchase volumes as at 21 April 2017 (at amortised cost)
BREAKDOWN OF HOLDINGS OF DEBT SECURITIES UNDER THE PSPP AS AT 31 MARCH 2017
Holdings as at Weighted average remaining
Issuer 31 March 2017, book value in EUR bn maturity in years
DE 355.59 7.65
FR 282.58 7.64
IT 245.58 8.72
ES 175.95 8.82
NL 79.54 7.83
BE 49.09 10.14
AT 39.10 9.31
PT 26.62 9.19
FI 23.53 7.26
IE 20.23 8.92
SK 9.08 8.09
SL 5.40 9.20
Supranationals 162.15 7.36
Rest 6.77 −
Total (incl. Supras) 1481.22 8.11
Past performance is not a reliable indicator of future results. Sources: ECB, AllianzGI Global Capital Markets & Thematic Research. Data as of 21 April, 2017. PSPP: public sector purchase programme, ABSPP: Asset-backed
Securities Purchase Programme, CSPP: Corporate Sector Purchase Programme.
Source: Allianz Global Investors, QE Monitor ‘The ECB’s exit: First things first’ 26 April 2017.
The ECB has stated that it will be tapering first and then considering rate hikes, so we are unlikely to
see any hikes until the end of 2018 at the earliest. Draghi has gone further by outlining four necessary
conditions for inflation to meet the price stability target before tapering can be considered. Inflation
must be medium-term, durable (not just driven by base effects), self-sustained (not reliant on the
extraordinary monetary conditions) and broad-based across the eurozone. It may be some time before
this comes to pass and, even if interest rates start moving at the end of next year, the balance sheet
still won’t shrink until 2020 or 2021.
12Leaders’ Perspectives – June 2017
What about Japan?
Japan was the first to use QE and the most likely This proved that “it is possible to exit from a period
to keep meaningfully extending its balance sheet of QE in a smooth manner, without overshooting
beyond 2017. In fact, Japan is potentially decades of inflation, derailing economic recovery, or
away from its desired inflation target and, even destabilizing financial markets.”2 Nevertheless,
if it is reached, it will have to be sustained for with the arrival of the global financial crisis the
a period of time before the idea of stopping QE BoJ was forced to enter another monetary easing
can be fathomed. Being the guinea pig for QE phase, having only raised rates back to 0.5%
has meant the BoJ has faced a great deal of leaving the exit incomplete and Japan with a
criticism, including claims that it waited too long persistently weak pricing environment. It feels like
to implement QE and tightened monetary policy years since ‘normal’ economic conditions have
too quickly. For the unwinding of QE, maybe the been here in Japan – maybe they will surprise us
BoJ will wait for the Fed to move so they can learn all and move first again?
from its mistakes.
An International Monetary Fund (IMF) paper
by Hiromi Yamaoka and Murtaza Syed called
‘Managing the Exit: Lessons from Japan’s reversal
of Unconventional Monetary Policy’ looked at what
we can learn from the BoJ’s first QE exit strategy.
This paper found that the gradual and orderly way
in which the BoJ unwound QE in 2006, with clear
indications given to the market, did not result in
any obvious disruption to financial markets.
2
https://www.imf.org/external/pubs/ft/wp/2010/wp10114.pdf
13Leaders’ Perspectives – June 2017
QE – When will we see you again?
Overall the inevitable unwinding of QE is getting Encouragingly, the Haldane et al 2016 BoE
increasing attention. Experts, including the IMF, working paper suggests that successive waves of
are warning that an unwind could cause a super QE have not been less impactful, so perhaps this
taper tantrum with increased volatility in the will be a useful tool in the future. Though Janet
markets and a fight for remaining liquidity, as the Yellen has made it clear when addressing the
supply of government bonds starts to disappear. Senate Banking Committee in her semi-annual
There is unlikely to be a way to avoid a sell off report to Congress that: “We do not want to use
when the ‘unwind’ begins. However, as long fluctuations in our balance sheet as an active tool
as inflation does not sky rocket, equities could of monetary policy management.” Let us see how
continue on relatively unscathed for a time. long the Fed sticks to that plan. For now, though,
QE has helped markets get back on their feet to
QE has served its purpose of being a life raft some extent and surely will have to be unwound
for many of the largest economies and now if central banks wish to keep it as a potential
central banks must start to go back towards measure again in the future.
the norm of pre-crisis levels, so that they have
ammunition to tackle the inevitable next crisis.
Also, surely central bankers will not want to keep
rates artificially low, as this could cause bigger
problems such as a bubble in the bond markets.
The developed world’s government bond markets
are already showing characteristics of a bubble.
However, if real interest rates were inappropriately
low, shouldn’t there be evidence of over borrowing
and inflation? Perhaps not, given the ever-present
reluctance of investors since the global financial
crisis after markets reacted so strongly to the
news of bank failures. Maybe central bankers
should use the focus the world’s media has on
politics to go under the radar and ‘sneak’ in some
rate hikes and reduce the balance sheet size while
the politicians steal the limelight.
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