Feature Stories | Oct 16 2014
By Greg Peel
While the past month’s pullback in global equities is largely attributable to sudden concerns with regard slowing global growth, Fed rate rise anticipation has provided a climate in which volatility is more likely to prosper. Indeed, the sharp ebbs and flows of US stock indices in recent weeks, including several 200-300 Dow point sessions in opposing directions, have been closely linked to meticulous analysis of Fed language and forecasting.
What markets fear is the first rise in the Fed funds rate since the central bank’s zero rate policy came into effect in 2009 in response to the GFC. Markets are assuming this is day the party will be declared over, that the Fed will no longer be supporting asset prices, and that, potentially, asset prices will need to de-rate rapidly as a result. It doesn’t seem to matter that while the first rate rise might be a significant milestone, the rise itself will be negligibly incremental.
It seems to have come down to whether the first hike will come as early as early as March, or in June as appears to be favoured at present, or actually later. Any swing in anticipation of the timing has the power to evoke such aforementioned wild swings in US stock prices. Yet while Wall Street agonises over what might be implied by “a considerable time”, no one seems to be concerned that come the end of this month, the quantitative easing program that began in 2009 will end.
QE was introduced after the Fed cut its funds rate to zero, for the simple reason interest rates cannot be cut to less than zero but the US economy needed further monetary stimulus. For the most part, QE involves the Fed buying bonds issued by the US Treasury and in so doing figuratively “printing money”, which is then able to be accessed by banks at a negligible interest rate to then be on-lent, so the theory goes, to corporations who will then invest that money, so the theory goes, in capex programs, plant & equipment and labour. The effect would be to stimulate an economic recovery.
The Fed introduced QE in 2009, which it followed with QE2 in 2010, which it followed with something dubbed QE2.5 in 2011, before finally launching QE3 in 2012. At each step, the Fed increased its balance sheet by buying Treasuries and other debt instruments such as mortgage-backed securities. In each of QEs one, two and three, the central bank expanded its balance sheet in monthly increments. Then in late 2013, the Fed announced that come 2014 it would begin to systematically “taper” the amount of each monthly purchase until that level reached zero after October.
Thus by next month, QE will be completed. To say QE will “end” is slightly misleading, although that is the expression being used, because the Fed will maintain the bulging balance sheet it has built up to provide support to the US economy, but just won’t add to it anymore. There were grave fears in 2013 that the day the Fed confirmed a tapering program was about to commence, markets would plunge into a protracted correction. That didn’t happen (indeed the Dow rose 200 points on the day), largely because of a lengthy “softening up” period from the Fed which left markets fully prepared, and also because the end of QE was indeed welcomed by a large percentage of market participants who simply wanted to see the central bank butt out.
One might also argue that by now, markets have been pretty well softened up for the first Fed rate rise. Indeed each day Wall Street falls in this current pullback, stock valuations are losing the premiums many an analyst were warning had become too stretched. Re-basing stock prices to lower level should dampen the impact of the first rate rise, which itself should be well anticipated.
But in turning their anxious attention to just when this first rate rise will be, global markets, by implication, have dismissed the actual “end of QE” as irrelevant and old news, even though it hasn’t actually happened yet. We’ve known since December last year that this day was scheduled to come, so it can hardly now be a source of volatility, one assumes.
Hayden Briscoe, Director – Asia Pacific Fixed Income for AllianceBernstein, begs to differ. “The timing of a rate increase is certainly important,” says Briscoe, “but focusing too much on it risks missing the big picture”.
The most profound change in the global monetary environment in the foreseeable future is not likely to be related to interest rates, but to balance sheets, Briscoe argues. The end of QE may have a greater impact on global markets than is currently expected, and investors may want to brace for some volatility ahead. To appreciate Briscoe’s argument we must look back not to the GFC as to when the problem began, but further back to early this century when a combination of the Tech Wreck and 9/11 encouraged then Fed chairman Alan Greenspan to engineer a period of low interest rates. The low rate structure then “went into full throttle” when Greenspan’s successor, Ben Bernanke, introduced QE as a response to 2008’s financial meltdown.
The effect of this central bank intervention was to shift the dominating market influence away from the “real” economy and that which would “normally” cause volatility in markets, such as political unrest, growth slumps or acute disinflation, and towards central bank balance sheets. By dominating money flows, central banks squeezed investors out of government bonds and forced them to seek income from riskier asset classes, such as high yield corporate bonds and equities.
Increasing demand for higher yield corporate bonds meant credit risk premiums compressed. A credit risk premium represents the difference between the rate at which the market is prepared to risk lending money to a company (by buying its bonds) and the rate at which the market would lend to the government (by buying government bonds), which is for investment purposes known as the “risk-free” rate. Such compression did not imply said corporations were any less of a credit risk, just that they offered a better return than the near-zero, or “negative real” rates on offer from government paper.
The cheapest form of capital is equity, but the more equity a corporation issues the more existing equity value is diluted. The converse is thus true, that the less equity a corporation has on issue the greater the valuation of that equity. Thus when corporations around the world, and in the US in particular, were offered the opportunity to borrow funds at near-zero interest rates and retire chunks of their equity by buying back their own shares, it was a no brainer. And when corporations buy back their own shares, the market jumps in on the act and pushes share prices higher.
Similarly, in a world where government bonds provide insufficient income, high dividend yields on equities compensate for the risk implicit in equities as an asset class and thus attract investors. As any Australian investor in bank shares over recent years knows, high yields translate into higher share prices. Thus one option for corporations with access to near-free money is to buy back shares, and another is to hand out attractive dividends. Note the following chart:
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This chart of US flow of funds data indicates that the correlation between net debt issuance and equity buybacks has been strongly positive. “As many in the market suggest,” notes Briscoe, “this liquidity or flow has been one of the key drivers of equity performance”. And while increased dividends and buyback activity has accelerated rapidly since the GFC, this chain reaction has actually been occurring for well over a decade. According to the Fed’s own data, corporations have been by far the biggest buyers of stocks since the beginning of the bull market in 2009.
US corporations have been expanding their own balance sheets (borrowing cheap money) because the Fed has been expanding its balance sheet, and rapidly so since the GFC brought about QE. So what happens when QE stops and the Fed balance sheet stops growing?
“When QE stops,” suggests Briscoe, “there won’t be as much excess cash flowing around anymore, so government bond yields may rise somewhat. This, in turn, may lead to risk premiums rising, which will then stop the equity-buyback merry-go-round, eventually leading to a broader pullback in the equity market which in turn will feed into aversion to riskier assets – essentially a reverse of what has happened for the past five to six years”.
The past five to six years have seen concurrent, and thus historically unusual, extended rallies in both equities and bonds (which in the latter case means falling yields). If we are to see a “reverse”, then bond prices will fall (yields rise), as everyone is anticipating, but in theory equity prices must also fall.
But wait! The US Federal Reserve is not the only balance sheet player in the game. The Bank of Japan has been aggressively expanding its balance sheet, the European Central Bank has recommenced expanding its balance sheet, and the People’s Bank of China has been implementing targeted monetary easing, suggesting that while Fed QE might be about to end, “global QE”, to stretch the definition, is not.
The problem, as Briscoe sees it, is that the impact of the BoJ’s QE has been relatively muted because Japanese investors have been slow to move out of their beloved government bond holdings, and because the yen simply does not have the same global clout as the US dollar global reserve currency. The ECB balance sheet has actually been contracting for the last several years and while president Mario Draghi wants now to expand it back to 2012 levels, the issue is just how this can be executed (when the eurozone has no common “government” bond). PBoC stimulus, while positive for market sentiment, actually has limited global impact given China’s is a closed-shop financial system.
Hence the conclusion is the end of Fed QE is likely to have a greater impact on global money flow than any net impact of QE elsewhere.
“That calls for investors to be cautious, in our view,” warns Briscoe. The US dollar has already strengthened significantly in anticipation of the end of QE, which has weighed on commodity markets, and provided a likely precursor of what is to come for bond markets. “In fact, we’ve already begun to see risky assets underperform. Hence, we believe it should be a warning to equity markets and other riskier assets as well”.
Technical limitations
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