Last week, the Federal Reserve Bank hiked the interest rate for the fourth time this year, and its chairman Jerome Powell said that there was no reason to change its plans to reduce the size of its balance sheet, which it started this year. Likewise, the European Central Bank (ECB) is formally ending its bond-buying program at the end of 2018, bringing to a close the historic balance sheet expansion that it started in March 2015. Of developed markets, only Japan will continue its QE program, along with other policies (fiscal stimulus and structural reforms) dubbed “Abenomics”, to boost Japan’s economy, although the Bank of Japan (BoJ) is currently tweaking its bond buying tactics.
What does this mean?
Central banks buying up debt and securities, in combination with ultra-low interest rates, have boosted capital markets as well as global debt piles. This era of quantitative easing (QE), which emerged as a response to the financial crisis a decade ago, is now coming to an end and has boosted the combined balance sheet of the ECB ($2.9 trillion), Fed ($3.2 trillion) and BoJ ($3.97 trillion) by roughly $10 trillion since 2007. The Fed and ECB will now stop reinvesting the proceeds of their assets (instead of selling their assets directly on markets), hence the unwinding of QE marks the beginning of “quantitative tightening” (QT), in which central banks “roll off” assets from their balance sheets to “normalize” their size.
Central bank balance sheet expansion has been unprecedented, so there are no historical comparable data to analyze and categorize the effects of this process. However, some observations from 2018 might become guiding principles in the next year and years to come. First, research shows that the unwinding of central banks’ stimulus has been the primary driver of asset-class performance this year, implying that classes that outperformed during QE might underperform during QT. Furthermore, as demand from central banks falls away, yields of debt – which move inversely to market prices – will rise, meaning that higher yields on government and corporate bonds in developed markets will hurt emerging markets in the coming years, which have already taken some punches this year as U.S. yields have started to climb. Likewise, this year’s return of volatility on U.S. markets might be a sign that investors are unsure how to respond to the era of QT.