Central banks are moving towards the ‘QE exit’. The US Federal Reserve (the Fed) this month began reducing the total size of its asset holdings bought under successive rounds of quantitative easing (QE). The European Central Bank (ECB) has just announced a planned reduction in the value of its monthly asset purchases. And the Bank of Japan (BoJ) has been quietly reducing the pace of asset purchases since it began targeting bond yields.
We’ve previously considered the potential impact of ‘QE exit’ on government bonds. In the US, for example, we think that the Fed balance sheet run-off could raise 10-year Treasury term premia by around 60 basis points relative to a status quo scenario. But this impact is far from certain, and we think that a plausible range for the potential impact is anywhere between a 30 and 180 basis point rise in yields.
We now turn our attention to the potential impact of ‘QE exit’ on equities. The apparently close correlation between the size of central bank balance sheets and the level of equity prices on the way up, and the potential vulnerability of equity markets against a backdrop of high valuations, means this is a pressing concern. Let’s start by thinking through the channels by which QE may affect equities:
1. Portfolio rebalancing: QE may induce investors to switch into longer duration or higher risk assets, increasing demand for equities;
2. Lower discount rates: lower government bond yields should reduce the rate at which investors discount future cash flows, raising the amount investors are willing to pay for those cash flows today;
3. Higher economic growth: QE may boost the level of GDP, meaning higher corporate profits, and therefore higher equity prices;
4. Stimulating ‘animal spirits’: the ‘shock-and-awe’ approach to QE announcements may increase investor confidence and reduce perceived macroeconomic tail risks, boosting risk appetite;
5. Exchange rates: by changing interest rate expectations and term premia, QE may have exchange rate impacts. For equity indices with a large exposure to exporters, or to companies with domestic costs but overseas revenues, this will impact equity prices.
These channels established, we are in a better position to understand how ‘QE exit’ might affect equities. Several points are worth making:
This isn’t ‘quantitative tightening’… At least not at a global level, not yet. Aggregate asset purchases of the G4 central banks (the Fed, ECB, BoJ and Bank of England) are set to drop steadily during 2018. But they are unlikely to turn negative for the foreseeable future. In particular, BoJ purchases should broadly offset the Fed run-off throughout 2019.
Terminal balance sheets will still be large… Even in the US, where the Fed’s balance sheet is now shrinking, its terminal size is likely to be much larger than was the case historically. This reflects the evolving way in which the Fed implements monetary policy.
Policy rates and the balance sheet have been divorced… Unlike during QE episodes, central banks have been keen to emphasise that there is little read-across from ‘QE exit’ to a quicker rise in short-term policy interest rates.
Equilibrium interest rates will remain very low… As and when interest rates are hiked, they are unlikely to rise very high. Equilibrium interest rates (the level at which rates should settle over the long run) appear to have fallen, reflecting lower trend growth.
Communication has been reassuring… The Fed’s slow and predictable approach to balance sheet run-off has been in contrast to the ‘shock-and-awe’ approach of QE announcements. The ECB’s extension-but-reduction in asset purchases, and the BoJ’s shift to targeting the price of government bonds (which has seen a reduction in the quantity bought), were also couched in language designed to reassure markets.
‘QE exit’ is happening because the economy is in better shape.
‘QE exit’ is happening because the economy is in better shape… Lower long term trend growth notwithstanding, current global growth is encouraging. The US labour market is strong and tax cuts may yet be passed, Europe has cleared several political hurdles, China has added significant fiscal stimulus, and many other emerging markets are reaping the benefits of a global trade upswing and structural repair work.
All this would seem to suggest that equity markets should not fear ‘QE exit’. With central bank balance sheets to remain large and quantitative easing not set to become quantitative tightening for a good while yet, portfolio rebalancing may not go into reverse. Slow hiking paths and low terminal policy rates mean that the present discounted value of equity cash flows is not about to plummet. Reassuring communication shouldn’t undermine animal spirits. Indeed, improving global economic growth should help risk appetite as well as corporate profits to hold up.
Nevertheless, there are two big caveats to our sanguine view that ‘QE exit’ won’t lead to a policy error. The first is that a withdrawal of unconventional monetary stimulus of this size is unprecedented. The one recent parallel – the BoJ’s balance sheet reduction of 2006 – did indeed see a sharp but temporary fall in equity markets. The second is that ‘QE exit’ is happening against a backdrop of high equity market valuations. That may mean that it could take relatively little to upset the applecart.