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Quantitative tightening depresses markets

John Redwood, Charles Stanley’s Chief Global Economist, looks at the market implications of central bank actions.

John Redwood

in Features


Opinion has been a bit divided about the impact of quantitative easing on markets, though most take the common sense approach that the massive buying of bonds by central banks boosted asset prices. It was designed by the Fed, the Bank of Japan and the European Central Bank as a means of lowering longer term interest rates by driving bond prices up and yields down. It was also meant to deposit more cash in the hands of banks and portfolio investors to spend on more adventurous investments. The hope was that this cash would generate more new investment and more consumption, as banks lent the money on and portfolio investors realised profits, lifting their spirits.


This would imply that now central banks are reversing this policy, you would expect bond prices to fall, and the amount of money available to lend on to reduce. Bond prices have been falling as rates rise. In the US, where this process is most advanced, the value of Treasury bills has fallen and longer-term interest rates have risen. The hope was that whilst the central bank was removing money from the system by this means, there would be plenty of money and credit flowing through the economy owing to normal actions by commercial banks. It is certainly true that this year as the Fed has toughened its stance and cranked up substantial quantitative tightening, the commercial banks have been able to assist people grow the economy at a decent pace. So far, so good.


The equity markets, however, are not so sure this happy conjunction of prudence and growth can continue. Analysts point to the fall in car and home sales in the US, as the costs of credit and availability of easy credit is adversely affected by higher rates and monetary action by the central bank. The growth rate of US money as measured by M2 has fallen to just 2%, worrying monetary economists that there will be a further slowdown in the US economy ahead. The Fed has given plenty of public warning of what it is doing in the hope this will mean it is not damaging to output. It is nonetheless tough action. The Fed’s balance sheet stood at $800bn before the banking crash. It reached a peak of $4.4tn after sustained programmes of creating money to buy bonds. This portfolio of assets is now being reduced by $50bn a month or $600bn a year, taking that much money out of the system as the bonds are repaid.


The European Central Bank has expanded its balance sheet almost fourfold as it counters slow growth and low inflation in its economic area. That bank too is about to end all new purchases, removing a useful source of new cash from the system. It is not yet about to cut the size of its balance sheet. Even the Bank of Japan, which has been the most expansionary of all the central banks with huge programmes of bond buying is now cutting the pace of growth in its portfolio. The Bank of Japan has almost quintupled its balance sheet over the last decade or so.


As we enter 2019 we need to expect the combined efforts of these three large central banks to be an overall reduction in bonds held and created money to finance them. The Fed will lead the way with quantitative tightening, but the other two will add insufficient new bonds to counteract the US measures. This is a different background to that of the decade from the crash when there was a huge cash injection.


Savers holding cash and deposits will benefit from this process as interest rates edge upwards. Bond prices in Japan and the Euro area could suffer as investors feel the removal of the large buying programmes that have sustained very high prices for a long time. The danger is the Central Banks overdo the quantitative tightening, slowing economic activity and reducing confidence. Part of the background to the sell offs in shares in February and October is this relentless tightening, with fears of more to come. Keynesian economists say recent slower money figures are not crucial, and expect commercial banks to be able to extend sufficient credit to keep growth going forwards. They would argue that as money growth slows so money circulation should rise if all is well with the underlying economy. Time will tell, but it does seem that Central Bank action is a bit of headwind that worries quite a lot of people in markets as well as President Trump. The best thing that could happen from here is the Fed toning down its hawkish language more and hinting that maybe it has raised interest rates enough, given the relentless reduction of its bond holdings at the same time. What the Fed does matters mightily for the world economy. As the Central Bank Governor of India remarked, if the Fed carries on like this the world will be short of dollars with damaging consequences for emerging market economies.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.


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