There weren’t many winners from the washout of the 2008 financial crisis, but as the efficient market theory floundered, Keynesian economic policy re-emerged to steady the ship. Easy money sloshed through the US economy and before long other countries were following suit.
One outcome is that fixed income volatility has been smothered even as fixed income prices have surged, thanks to a mix of zero-bound interest rates in major economies and massive central bank bond buying programs. While all this has narrowed the fixed income opportunity considerably, volatility remains in currencies, an asset class which has proven more price sensitive to shifts in economic policy.
Quantitative easing swelled the US Federal Reserve’s balance sheet as it went all out to kick-start the economy. While QE in the US has been halted, it continues apace in Europe and Japan. Even China is doing its own form of QE via the loan to bond programme for State Owned Enterprise debt – mostly being bought by China’s three policy banks.
Economic purists may decry these kinds of unconventional measures, but central banks aren’t going to be indifferent bystanders when economies are floundering. So thumbs up to central banks for stepping up and doing whatever it takes to revive inflation from unusually low levels and to encourage investment and consumption.
But there’s also been a downside: bond prices have pushed up steeply and yields have shrunk.
In Europe, the net annual supply of bonds has fallen into negative territory on the back of ECB buying and fixed interest investors need to go out 7 years on the maturity spectrum before running into positive yields. On the JPM Global Government Bond Index, there is $2.9 trillion (or 13.5 per cent) worth of assets now trading with a negative yield.
The end result is that bond prices have hit great heights and they’re no longer moving as strongly with monetary policy announcements as might be the case in ‘normal’ circumstances.
How could they when the largest actors by-far are major central banks buying securities?
But volatility has not vanished. Investors just need to move down the road into currency markets where there isn’t this huge one way bid.
Whether central banks are explicit about it or not, a key intended consequence of unconventional monetary policy is currency depreciation and the battle for inflation. The fight for moderately positive inflation shows just how much the world has changed.
Central banks fought for several decades to bring inflation under control. Now the fight is to lift inflation from unusual lows. But that’s an aside.
Easy money is always going to lead to some level of depreciation of a country’s exchange rate. In fact, this is an important outcome. Increased buying in a certain denomination should boost inflation as imports become more expensive and exports become more competitive.
This is a potent channel through which QE impacts the real economy and for fixed interest investors it represents a welcome source of volatility when bond yields have flattened.
There was a good example of this in early 2015 when a significant number of countries cut rates in surprise moves in quick succession in order to arrest the appreciation of their currencies. Australia joined the bandwagon too – the rate cut in February certainly had the hallmark of ‘if you aren’t cutting you’re hiking’ about it.
Finding the right balance is the key and many central bankers have waited in anticipation for the US Federal Reserve to finally initiate the lift-off in rates. Through 2015 the FOMC remained painfully cautious. They were all too aware that monetary tightening at home would see the Greenback appreciate, while at the same time taking the pressure off other major currencies such as the Euro.
Mid-way through 2015 saw the push out of the Fed’s first hike, causing the EUR to rally (USD to fall) and exacerbating the need for more QE in Europe.
This flowed into December but this time around the ECB’s stimulus announcement surprised the market by locking in less easing than had been anticipated. The deposit facility rates were cut from -0.2 per cent to -0.3 per cent, but the size and increment of the asset purchase program was lean.
The Euro appreciated immediately, which was not ideal, but the alternative (ramping up QE) would have certainly inflamed the currency wars as other economies worked to drive their own depreciation.
In mid-December the FOMC made their most anticipated announcement of the decade with a rate hike that saw an immediate slip in the Euro against the USD. As funds headed back to a resurgent USD there were tentative signs of relief from ailing economies which had been struggling to keep their heads above water, yet still, they were far from reaching dry land.
Japan has been mired in slow growth for many years but its easing program has remained relatively steady for a year now. As Europe continues to ease further, the BOJ will be feeling the pressure to do more on the depreciation front. In December the BOJ increased the duration of its purchase programme – reaching further out the yield curve for its monthly JGB fix.
With monetary policy rates at or near zero for many of these countries – currency is the battleground and it’s where the volatility is – there is an asymmetry to how rates can move given the close proximity to the lower bound.
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