Author: Hamish Douglass – CEO and Portfolio Manager, Magellan Global Fund
Since late 2008, the United States Federal Reserve has grown its balance sheet dramatically via massive bond-buying programs designed to reduce long-term interest rates in the United States. This has squeezed investors out of the US government bond and mortgage bond markets, forcing them to chase higher investment returns elsewhere. As a result, other asset classes have benefited. The major issue for the United States Federal Reserve will be how it implements its policy to unwind Quantitative Easing (QE) without reversing these effects or triggering major market dislocations around the world.
The critical issue is that most of the cash paid out by the United States Federal Reserve (to financial institutions) over the course of its asset-purchase programs is still being held as excess banking reserves at the United States Federal Reserve itself. If this money was injected into the US economy, via bank lending, it would cause massive expansion of the money supply, potentially with adverse inflationary implications. To prevent this, the united states Federal Reserve would have to either substantially reduce the scale of the results (such as increasing the interest rate payable on excess reserves, selling assets directly in the open market or raising bank reserve requirements), these tools present their own problems.
There is no good historical precedent that can guide us as to what will happen in markets as QE unwinds. However, we see two main scenarios that could play out:
1. An orderly unwinding of QE
This scenario is predicted on a steady, but not sharp, US economic recovery with a gradual increase in the demand for credit. With this backdrop, it is likely that the United States Federal Reserve could gradually reduce excess banking reserves, by utilising a combination of policy tools, without any real threat of materially higher inflation expectations. Under this scenario, we would expect elevated market volatility and, potentially, some dramatic re-pricing of certain asset classes. We view this as the most likely scenario and one that does not overly concern us from an investment or portfolio perspective.
2. A disorderly unwinding of QE
This scenario could be triggered by a sharp US economic recovery coupled with a strong demand for credit. Such a scenario could be driven by a strong improvement in US house prices and a significant increase in demand for consumer credit, such as home equity loans. Under this scenario, long-dated bond yields could start increasing rapidly as markets lose confidence in the United States Federal Reserve’s ability to exit QE in an orderly manner.
A rapid rise in US long-dated bond yields would likely cause massive market dislocations and increase global systemic risk. We could see large and rapid falls in asset prices, major moves in currency markets and massive global monetary flows. Liquidity could be rapidly withdrawn from certain emerging markets, which could trigger an event similar to the 1997 Asian crisis. We also believe that a rapid rise in longer-term US interest rates is very likely to drive up corresponding interest rates around the world. This could place enormous pressure on certain European countries and could re-ignite the Euro-crisis.
The difficulty in trying to assess how this situation will end is that it is likely bond investors will re-price longer-dated US bonds to more normal levels prior to the United States Federal Reserve unwinding QE.
This increases the risk of a disorderly unwinding of QE as bond yields will already have moved higher when the unwinding actually begins. We continue to monitor the possible warning signs to determine whether the probability of the disorderly scenario is materially increasing. Overall, however, we assess the risk of a disorderly unwinding of QE to be a ‘fat tail’ or low probability scenario. Unfortunately, as we have repeated on many occasions, low probability does not mean zero probability.
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Source: The Charter Journal