Easy money: the risks of quantitative easing

While some may call this “printing money”, in fact quantitative easing is something very different. It involves the purchase of financial assets financed by the issuance of central bank reserves. The impact of this issuance or creation is the increase of money in the system. A central bank, acting as the banker to a nation, will increase the monetary base held electronically and draw on this to finance asset purchases. This enables financial entities to create more credit and to stimulate the level of nominal demand in an economy.

Under normal market conditions, central banks can determine the growth rate of credit (and wider measures of money) through adjustments in their policy rate. As an example, lowering the policy rate increases the demand for credit. When monetary stimulus creates too much demand, inflation can occur.

Effects
What are the desired effects of quantitative easing? It assists in lowering bond yields, which makes it cheaper for individuals and businesses to borrow and makes it less likely they will default. As well, it provides direct lending and liquidity to credit markets and the financial system, maintaining the supply of broad money in the system which can then be leant out to stimulate economic demand. The third goal is to assist central banks in their inflation targeting efforts to create and withdraw inflation as required.

Central banks chose different methods of quantitative easing, tailored to that particular country’s specific needs. The U.S. Federal Reserve focused largely on purchases of mortgage debt issued or backed by the government sponsored agencies—Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—but also acquired a significant amount of Treasuries. The Bank of England initially focused on commercial paper and corporate bonds, but ended up acquiring mostly nominal Gilts. The European Central Bank decided not to use outright asset purchases, but instead used long-term refinancing operations (collateralized lending to banks), a most unconventional approach. Our own Bank of Canada resisted the urge to engage in formal quantitative easing, though did help support the Canadian banks in an effort to prop up their balance sheets and level the playing field.

Exit strategies
A year on, central banks have indicated their desire to remain flexible should economic and monetary conditions warrant it. However, they are beginning to communicate exit strategies in an effort to manage the reduction in monetary stimulus as deftly as they managed to re-inflate the system.

• The Bank of England has recently extended its Asset Purchase Scheme, but with much reduced speed of purchases. The U.K. economy has been particularly hard hit and there are fears of a Japan-style lost decade. The fear is, if quantitative easing measures are withdrawn too quickly, the Pound will increase, making exports too expensive and quashing the fragile economy, thereby requiring further quantitative easing.
• The U.S. Federal Reserve has finished purchases of U.S. Treasuries, reduced the amount of Agency debt it is planning to acquire and has slowed purchases of Agency debt and mortgage backed securities. Recent GDP numbers from the U.S., as well as a stabilized unemployment number are raising hopes that the worst is over for that country. However, fears remain that the without government stimulus programs such as Cash For Cars and the need to somehow manage its burgeoning budget deficit, the U.S. may not be out of the woods yet.
• The European Central Bank announced that it will not renew some of the longer-term lending facilities in 2010. Market expectations are that policy rates will start to go up from mid-2010, which is consistent with economic growth in many of the European countries.

Risks
The risks to not managing a benign exit are:

• Inflation over the medium-to long-term.
• A new bubble in financial markets driven not just by quantitative easing but also by pegged exchange rates.
• Increasing yields and the need for more quantitative easing as unexpectedly large budget deficits could create an excess of supply relative to demand.

While we do not believe these are the most likely outcomes, they remain material risks to the system and need to be monitored. Inflationary concerns have emerged globally, though there is little evidence that actual inflation is an issue in most countries (rather deflationary fears continue in many). The weakness of the U.S. dollar, a currency often used for global trade, as a store of wealth and in maintaining fixed exchange rates, has spurred purchases of gold bullion by some. It is notable that the central banks of India, Indonesia and Mauritius have begun purchasing gold.

Given the risks to inflation in the medium-and long-term, hedging your inflation exposure makes sense. This can be done through the purchase of real assets (including commodities, real estate, infrastructure), inflation linked assets (real return or index linked bonds) or inflation derivative strategies.

While we do not see evidence of asset bubbles forming despite the rapid increase of many equity markets since March 2009, the risk remains. Equity option strategies can be employed to manage this risk. It is also clear that some equity markets may not perform as well as others. Growth expectations for the U.K., as an example, are below that of many other countries, while the U.S. economy remains fragile. Conversely, the prospects for many other countries (and their markets) are quite positive, including many of the emerging market economies.

Bonds
Bond pricing is the function of a number of different and interrelated factors including short rate expectations, future economic growth and inflation, and the issuance and demand a variety of financial investors. If budget deficits are larger than expected over the next few years, then a large imbalance between supply and demand could push up real bond yields (and force more central bank repurchases). We believe the market is already anticipating the end of quantitative easing and the supply/demand imbalances that may exist. That being said, sovereign credit and currency risks from some of the world’s largest economies issuing this debt, including the U.S. and the U.K., argue for rising bond yields.

Debt maturity risks also need considering. The risk is for higher yields especially, at the back-end of the curve, since debt issuance globally is lengthening in maturity to reduce roll-over risk and to take advantage of lower long-term rates. The implication of this is the potential for steep yield curves, even during the recovery phase.