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Thursday, April 17, 2014
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The End of Quantitative Easing

Written by Daan Harmsen, FINANCIAL MANAGER, GEOCAPITAL MICROFINANCE ORGANIZATION

08/07/2013 11:12 (282 Day 10:50 minutes ago)

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The FINANCIAL -- In my last article, I discussed what quantitative easing is, and how it works. In this article, I will discuss the end of quantitative easing, and what the consequences might be for the U.S. and world economy.

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Just to refresh your mind: quantitative easing is the process whereby during and after the financial crisis, the United States Federal Reserve (the country’s central bank, also called “the Fed”) bought up trillions of dollars of government bonds and mortgage bonds in order to lower interest rates and stimulate the economy. Right now, it is buying $40 billion of mortgage bonds and $45 billion of US government securities every month. Because the American economy is improving, the Federal Reserve is thinking about how to stop the quantitative easing program, in order to prevent the economy from overheating and to avoid excessive inflation. In this article, I will discuss three of the main consequences that this will have: a rise in interest rates, a move out of “risky” assets such as stocks, and money flowing out of emerging market. I will also explain the rationale behind ending quantitative easing.

The market panic -- In market parlance, the gradual ending of quantitative easing is called “tapering”. This involves the Fed reducing its regular purchases of bonds in the market, and then later selling back inventory to the market.  When during a recent Fed meeting in June, its chairman Ben Bernanke hinted at possible tapering in the future, market participants got scared, and the markets slumped. In June alone, mortgage bonds, which have been pretty stable over the past few years, lost more than 4% of their value. The stock markets also suffered, and interest rates for mortgages went up. The yields on government bonds also went up, making it more expensive for the government to borrow money.

RIsing interest rates -- Why did the market get so scared? In simple terms: they will lose the extra “free money” that has been flowing around in the markets for the past few years, which was effectively printed by the United States Federal Reserve. This means reduced demand for the securities that the Fed was buying: if it will no longer buy government bonds, mortgage bonds, or other securities, interest rates on these securities will go up. The effect of a big player like that leaving the market is huge: think about what would happen if Apple suddenly stopped buying gorilla glass - an important component of its phones. The price of gorilla glass would drop like a rock! Because the prices of these securities that the Fed will stop buying will go down, of course the any rumor of the end of quantitative easing will cause the prices of these securities to drop immediately. This may cost investors a lot of money: JP Morgan Chase analysts have estimated that for every 1% increase in yields, banks stand to lose as much as $30 billion dollars.

Stock market risks -- However, other securities as stocks, will also suffer. When the Fed buys securities, it puts money in the hands of investors, who may use that money to buy for example stocks. If this money starts being “drained” from the markets by the Fed, investor demand for stocks may be reduced. Another asset class has already suffered large losses: gold has traditionally been used as an inflation-hedge, but because inflation has largely been absent, and probably won’t come about in the near future, one of the prime rationales for holding gold has disappeared.  Another effect of an increase in interest rates will be higher mortgage rates, meaning that people in the United States will have to pay more interest on new mortgage loans. Because borrowing becomes more expensive, house prices may suffer: if borrowing becomes costlier, people will be less likely to buy (expensive) houses.

Emerging market risks -- Furthermore, we will see an outflow of money from emerging markets. When interest rates reached record-lows, many investors started “reaching for yield”, which is a technical way of saying that they looked for other markets to make money. Emerging markets offer that yield: the returns offered are often substantially higher than in developed markets. If you can make 8% lending to a Brazilian company, that might be a lot more attractive than lending to an American company at 4% However, now that interest rates in the West will increase, Western investors will again be able to find yield at home, so they will move some of their money out of emerging markets.

Reasons for tapering -- So if the “tapering” of quantitative easing has all these negative effects that I described before, then why is the Federal Reserve doing it? Whenever you pump a lot of new money into the economy there are two major risks: inflation and asset bubbles. We haven’t really seen much inflation in the United States or around the world: in fact the Fed’s monetary policy committee wrote in its latest statement that “inflation has been running below the Committee's longer-run objective”. Bernanke has actually been trying to target a slightly higher level of inflation. However, the Fed is somewhat worried about asset bubbles. Individual members of the Fed board having voicing concerns about asset bubbles building, especially in the credit markets. For example, in a recent speech, Federal Reserve Governor Jeremy Stein said that “we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.” What Stein (disclaimer: my former professor) is saying here is that because of low interest rates in the economy, there is more demand for higher-yielding bonds, but that they have become unsustainably expensive: he thinks that the actual default risk of these instruments is higher than the market thinks

After Bernanke went on record and talked about tapering, the markets were in shock, and responded in a way that they Fed had probably not expected. Over the days that followed, several Fed members made statements saying that tapering is still far away, to try to calm the markets. The Fed line is now that it may start to reduce the speed of asset purchases later this year, and end asset purchases around mid-2014, if the unemployment rate is around 7%.This will be a very exciting but uncertain time in financial markets, as the largest and most novel financial experiment of our time will come to an end.

 

GEOCAPITAL MICROFINANCE ORGANIZATION

 

 

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