In the eurozone the initial step of tapering the European Central Bank’s asset purchases has likewise been broached, though not in as many words. The Fed recently officially mooted the prospect of reducing its balance sheet. Its purpose in doing so has been to prepare investors for the coming move.
Obviously the Fed is paying close attention to its wording so as not to repeat the mistake of the previous tapering, when Ben Bernanke sent a shudder through the markets by springing the Fed’s tapering plans on investors without prior warning.
Actually in Europe, tapering has already begun officiously as the ECB reduced its bond purchases in April.
Actually in Europe, tapering has already begun officiously as the ECB reduced its bond purchases in April. And Mario Draghi recently admitted that while the ECB’s monetary policy has to remain very accommodative, it will also be adapted to its environment so as not to be overly expansive. On the face of it then, the bond purchases programme will very likely go on being tapered if the economic upswing continues.
Although numerous studies have examined the impact of quantitative easing on the economy and the markets, less research has been done on central banks’ moves to shrink their balance sheets or slow their rate of growth. This is because few experiments of this type have been conducted in the relatively recent past.
Unsurprisingly, however, those studies that have been done indicate slightly negative effects on economic growth, bank lending, inflation and stockmarket returns. In fixed income we can see how quantitative easing programmes have lowered the general level of yields and also flattened interest-rate curves. The prospect of these programmes being scrapped means we will have to foresee sharply steepening rate curves in our scenario. As a matter of fact, we are already cautious regarding duration in our bond allocations.
It is important to note that this process can be factored into a broader context which, by and large, is reassuring. In broaching the idea of reducing its balance sheet, the Federal Reserve is displaying caution because US inflation and wage growth are both still low. We can therefore expect its asset sales to be similarly slow and gradual to make their impact on the economy and the markets as neutral as possible. The ECB meanwhile will probably tiptoe even more lightly if it takes a clear step in the same direction. The purpose of its quantitative easing was to ease credit conditions in the peripheral eurozone countries and this worked well. But these economies have turned up much too recently to decide to put paid to QE abruptly.
So, as we can see, ending quantitative easing programmes and selling the assets they have produced are intriguing issues. The unconventional monetary policies involved, which sprang up quite recently in the developed countries, were unprecedented and have had powerful repercussions on the markets, even though the magnitude of these effects is still in question.
Head of Asset allocation and Sovereign debt
So, as we can see, ending quantitative easing programmes and selling the assets they have produced are intriguing issues. The unconventional monetary policies involved, which sprang up quite recently in the developed countries, were unprecedented and have had powerful repercussions on the markets, even though the magnitude of these effects is still in question. This makes analysis uncertain.
While reducing central banks’ balance sheets could have adverse effects on stock and bond markets, in the case of the Fed it is clear that its early guidance and the modest scale of its plans are meant to smooth out these repercussions. Central banks have chosen to move despite prevailing economic conditions but it is likely their attitude will reassure markets as it guarantees a gradual approach and even the possibility of reversing course if necessary.
We therefore regard central banks’ treatment of their assets—treatment that up to now has buoyed the markets and will henceforth become slightly negative— as a change of direction that may cause volatility but should not change the playing field fundamentally.
Head of Asset allocation and Sovereign Debt
Edmond de Rothschild Asset Management
This analysis is an extract from the first House View published by Edmond de Rothschild.
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