The Fed and ECB at a crossroads: Unwinding QE
Last week, the European Central Bank dropped the easing bias from its communique, while the Federal Reserve's FOMC is meeting on 13-14 June with speculation high that they will raise rates yet again. After years of quantitative easing and low interest rates, the Fed and, to a lesser extent, the ECB appear to be ready to get out. Both central banks are at a crossroads as the decision to unwind QE could prove to be fatal or come at just the right time.
We asked Dr. Constantin Gurdgiev, who runs the blog True Economics as well as the website MacroView, for his thoughts on the matter. More specifically, how exactly will the Fed unwind its multi-trillion dollar balance sheet without severely upsetting the bond and equity markets and how will the ECB, which is still stuck in a quantitative easing cycle, be able to bring it to an end without plunging Eurozone countries into yet another financial crisis?
Dr. Constantin Gurdgiev is Professor of Finance at Middlebury Institute of International Studies at Monterey and continues as adjunct assistant professor of finance at Trinity College, Dublin. He is a co-founder and director of the Irish Mortgage Holders Organisation. Constantin is proudly a board advisor to Aid:Tech, a revolutionary blockchain technology firm that works to merge technology and aid. He serves as a partner and a board member with a number of international financial services providers, and he is the board member of ICham Irish Chamber of Commerce in Central and Eastern Europe. Dr. Gurdgiev was one of FocusEconomics's Top Economic and Finance bloggers of 2016. Visit his blog True Economics as well as his website MacroView for more from Constantin. You can also follow him on Twitter here.
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Years of unprecedented monetary policy ‘accommodation’ around the world has resulted in severe mis-pricing of key risks by the global bonds and equities markets. Given the depth of the government debt markets and their pivotal importance to key long-term investment markets, such as pensions funds, insurance companies and retail investors, and given the strong channels for spillovers/contagion from the bonds markets to equities, both markets are now primed for a massive correction, once interest rates reversion to the historical mean takes hold. This mean reversion is now looming as the Central Banks - from the U.S. Fed to ECB and Bank of Japan - either contemplate or already acting to raise rates and reduce their balance sheet exposures accumulated during the period of the crisis.
Take for example U.S. Treasuries. Since mid-2013 through today, U.S. Treasuries yields have closely followed global CPI measures, with the gap between U.S. 10 year yield and the IMF-measured Global CPI gauge widening starting in mid-2015. Currently, 10 year treasuries are trading at a yield of around 2.2 percent against the Global CPI closer to 2.8 percent. This represents a reversal of the historical relationship over 2000-2007 period, when yields on the U.S. 10 year bonds run at an average premium on Global CPI gauge.
In simple terms, the further the U.S. Treasuries depart from the Global CPI, the greater the negative impact on the U.S. bonds prices will be once the Fed and the global Central Banks get serious about moving toward higher interest rates. And, in line with this, the greater the negative impact will be on financial services intermediaries and investors heavily dependent on U.S. and other advanced economies' bonds. Given the complexity and the severity of contagion channels through which bonds repricing in the global markets can impact investors’ portfolios valuations, returning U.S. treasuries and other government bonds markets to more realistic, fundamentals-justified risk valuations threatens severe corrections in both debt and equity markets worldwide.
The Fed has already started to gradually unwind its monetary accommodation, primarily through recent rate hikes, but also by curtailing active purchasing of the U.S. Treasuries and agency debts, as well as MBS. Since mid-2014, the Fed balance sheet remains flat, while reserve balances held with the Fed have declined marginally. Thus, total balance sheet exposure by the Fed is running at around USD 4.4 trillion, unchanged from the start of 2017. The next steps of unwinding for the Fed are likely to involve 2-3 more interest rates rises in 2017 and gradual reductions in assets rollovers (purchases on new securities that are issued to roll over maturing assets). However, this gradualist approach to monetary policy tightening will likely lead to markets taking Fed policy changes as forward guidance for 2018-2019 policies, resulting in potential repricing of risks ahead of actual policy changes. This, in turn, presents a significant risk of a severe markets correction towards the end of 2017.
An added risk dimension here relates to political risks and economic policy shocks that can simultaneously push up inflationary expectations (e.g. Trump Administration proposed tax reforms and a patent lack of budgetary discipline are both inflation-positive) and create an added safe haven demand for financial assets (e.g. ongoing and expanding geopolitical tensions and domestic investigations relating to the Presidential Administration are both equities and U.S. bonds negative). These factors, if they coincide with the Fed policy tightening, will further exacerbate any equities and bonds prices correction, and can lead to a potential run on the markets. Beyond this, Fed tightening runs against the massively expanded debt exposure for the U.S. and global corporates and the U.S. households. This channel of monetary policy tightening impact risks triggering a new debt recession with likely global implications.
Hence, the Fed finds itself in an extremely sensitive position. Even a moderate tightening path to policy normalization can result in a severe market crisis with strong contagion channels to systemically-important financial institutions, including larger banks, pension funds and insurance companies. On the other hand, continuing with business as usual monetary policies means risking an inflationary uptick that cannot be addressed without forcing the U.S. economy into another recession. It further undermines sustainability of the U.S. public and private pension funds. In one key example, in 2016, CalPERS, the largest public pension system in the U.S., covering public pensions provision across California, has generated a return on its investments that is more than ten times below the long term sustainable rates of returns factored into its contractual pensions payouts. The longer the current period of monetary accommodation lasts, the more insolvent public pensions across the U.S. become.
In its latest guidance, issued on 8 June, the ECB remains committed to the promise of continued monetary expansion over the course of 2017. In line with this, the ECB continues to aggressively accumulate assets, with the end-of May balance sheet sitting at USD 4.6 trillion, above the Fed’s USD 4.4 trillion and BoJ’s USD 4.5 trillion balance sheet exposures. Like the Fed, the ECB is facing the same monetary policy dilemma. Inflationary expectations are rising in the Euro Area, with short-term indicators for inflation currently at or above the ECB policy target levels and medium-term HICP close to the target. At the same time, long term viability of the current debt-fuelled expansion rests solely on the assumption that the low interest rates environment will remain in place well into 2020 and beyond. Spillovers in assets demand from the U.S. and the rest of the world into the euro area have triggered similar risk mis-pricing in European equities and bonds that characterizes the U.S. markets. In contrast to the U.S. and Japanese monetary authorities, however, the ECB is currently running too close to exhausting the supply of key benchmark German bonds it can buy over the rest of 2017. Given idiosyncratic nature of ECB mandate and the complex structuring of its asset purchasing programs, this problem of dwindling supply of German (and other highly rated) government bonds available for purchases under the ECB programs imposes significant risk spillovers from the Frankfurt policy to private sector financial intermediaries, including pension funds and insurance companies, as well as the banks.
In other words, like the Fed, the ECB is at a cross roads when it comes to its policies forward: either tighten rates and balance sheet exposures soon in order to bring asset markets bubbles under control, or continue to inflate the debt bubble. The former option risks triggering a market crash and a recession, just as the labour markets starting to slowly recover from the previous crisis, the latter option promises to create an even greater blowout in the future.
Given these choices, the ECB is likely to continue monetary accommodation into 2018, while starting to ‘taper’ the rate of its balance sheet expansion. Unlike the Fed, the ECB will hold off from non-replacing maturing assets with new issuance purchases for as long as it can in hope that either Frankfurt can restructure its asset holdings away from strict GDP-share targeted sovereign exposures or that Brussels comes up with a reasonable burden-sharing fiscal harmonization plan.
5-year economic forecasts on 30+ economic indicators for 127 countries & 33 commodities.
Date: June 13, 2017
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