From QE to QT - whither global liquidity?

The Fed heads towards QT

The long road from financial crisis to recovery passed another milestone in September when the Fed announced that it would start to reduce its $4.5 trillion balance sheet from October.

The asset purchase programme, or quantitative easing (QE), is finally being unwound with the US central bank set to allow maturing bonds to run off its balance sheet rather than continuing to roll them over.

The process will start slowly with an initial $10 billion of Treasuries and mortgage-backed securities (MBS) being allowed to run off per month.

However, this will step up by $10 billion every three months until it reaches a cap of $50 billion per month. At this point the actual pace of balance sheet reduction will depend on the flow of maturing bonds, but it will mark a meaningful change in liquidity. The move toward quantitative tightening (QT) has begun.

The shift from QE to QT is a welcome development as it signals another step toward normality after the global financial crisis. The Fed has been transparent in its signalling and while bond yields in the US may experience some upward pressure, they should remain underpinned by the good behaviour of inflation and declining estimates of long-run equilibrium interest rates.

Looking at the wider picture, even with QT, global liquidity should continue to rise over the next 12 to 18 months, largely supported by the Bank of Japan.

Global liquidity set to wither

However, while all this is reassuring for markets and risk assets, we would inject a note of caution.

First, the pace of liquidity expansion will slow as the Fed implements QT and then as the European Central Bank (ECB) tapers QE.

Moreover, ECB tapering may bring bigger swings in capital flows and yield shifts given the impact of its QE on portfolios. As core yields rise in the eurozone there could be problems for peripheral economies that no longer have the central bank backstopping their sovereign bond markets.

Furthermore, we question whether we can talk of global liquidity when international investors have to take account of currency and hedging costs in assessing returns. The current configuration of interest rates may keep capital at home rather than flowing freely from areas of QE to those with QT.

The bottom line is that not all QE is equal and although global liquidity will not dry up, it will start to wither as we head into 2018.

UK: The unreliable boyfriend is back

Here we go again. The BoE’s monetary policy committee (MPC) has strongly suggested that it is finally ready to raise interest rates after over a decade of cuts and inaction. However, many are puzzled by the sudden change in communication, especially as data suggests the economy is very fragile at present, and is facing enormous uncertainty as Brexit negotiations unfold.

The unexpected shift in language caught investors by surprise, and has prompted many economists to revise up their interest rate forecasts. The rising probability of an earlier rate rise in markets has not only caused bond yields to rise, but also the pound to strengthen against most currencies.

Of course, the Bank has previous form in raising expectations only to fail to deliver, which is how it earned its nickname of the “unreliable boyfriend”.

Rate rises may expose vulnerabilities

The BoE is not pre-committed to raising interest rates in November, but it may be forced to follow through. It has very little credibility left with markets, and a dovish turn would cause sterling to fall sharply. Activity data between now and then is likely to improve, but not be particularly strong, which makes it more likely than not that a rate rise is imminent.

Raising the policy rate back up to 0.5% is unlikely to have a significant direct impact. Even if there was another rise or two, the impact on the economy is likely to be minimal given how aggressively households have deleveraged (i.e. reduced their borrowing) since the financial crisis. Lending practices have been tightened up, and banks have shored up their balance sheets.

Households have managed to maintain spending despite falling real disposable income largely thanks to a fall in household savings. For many households, this has meant taking out loans to make ends meet. But what if confidence was hit and households decided to raise precautionary savings? This could easily tip the fragile economy into recession.

November hike expected

With Brexit providing additional uncertainty, we forecast the BoE to only hike once (in November), but then be forced to wait until the economy returns to a stronger footing, which is unlikely before Brexit is complete in 2019.

Ideally, rate rises need to be gradual, limited and timed with an upswing in the economy, or at least confidence. The last part seems to be the bit that the Bank of England is missing.

EM disinflation: The end of a trend?

Disinflation has been a common trend in emerging markets (EM), prompting considerable inflows to EM debt, on the expectation of easing cycles by EM central banks. Now, after such large and sustained falls in price growth, the question increasingly being raised is how much further this process can run.

Currency strength: The EM appreciation society

EM currency movements have been an important contributing factor to disinflationary trends with currency strength having held down the cost of imported goods. However, since March this year, trade-weighted EM currencies have been losing momentum, and this may already be transmitting to inflation for the bloc as a whole. Unless we see a renewed trade-weighted strengthening of EM currencies, this particular tailwind looks to have passed.

The silver lining of weak growth

For emerging markets, the years since the global financial crisis have seen a steady downward trend in real growth rates, which (with a lag) has also meant a downward trend in inflation. However, there are signs now that EM growth may have bottomed, and consensus forecasts are for stable growth at least next year. So again, the disinflationary pressures for broad EM from this driver are likely spent.

Seas of wheat, oceans of oil: The impact of commodity prices

Dramatic falls in oil and agricultural commodity prices have also helped contain domestic inflation in many EM economies. This tailwind looks to be fading, if not already exhausted though. Oil prices have been climbing this year, and although we are not commodity experts, it does seem likely that the biggest windfalls have been reaped.

Policy and investment implications

Overall then, the disinflationary trend in EM and the rate cutting cycles which accompanied it seem to have largely come to an end. With inflation stabilising and likely accelerating from here, most central banks will find themselves unable to ease further (although there will be some exceptions).

Equities should still benefit, for the most part, from the stronger growth environment that lower real yields facilitate, while stronger inflation can be of some benefit to earnings. EM debt, on the other hand, will become more of a carry1 story as the prospect of further yield reductions recedes. 

1. A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return.

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