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What is Quantitative Easing (QE)?
Quantitative easing (QE) is an unconventional expansionary monetary policy that central banks have turned to once they have reduced their own policy interest rates to, or close to, zero. The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market. This increases the amount of money in the financial system, which encourages banks to lend more and can push interest rates lower, which encourages businesses and households to borrow. In turn if businesses use the money to invest and consumers spend more, this can give the economy a boost.
What is Quantitative Tightening (QT)?
Quantitative tightening (QT) is a contractionary monetary policy that is the reverse of QE. The government bonds and other assets that central banks have bought from the market through QE programs are held on their balance sheets, massively increasing their size. QT occurs when central banks start to reduce their balance sheets. In 2019, the US Federal Reserve is allowing its bond holdings to mature rather than replacing them. This is known as passive tightening. The Bank of England and European Central Bank have stopped their asset purchase programs but are not yet reducing their balance sheets. This means their balance sheets will shrink relative to GDP over time, which is known as organic tightening.
Why does it all matter?
Investors are concerned that quantitative tightening could significantly impact markets. Over the past ten years, asset returns have displayed a high correlation with central bank purchases. And recently, the Fed’s balance sheet run-off was cited as a contributory factor in the sharp sell-off in risk assets in December, which left the S&P 500 almost 20% below its peak. Taking those two factors into consideration, it is clear that investors are concerned. After all, if QE had a significant impact on markets, then wouldn’t QT have the reverse effect?
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Our view:
We believe that the overall direct impact of the Federal Reserve's quantitative tightening program is likely to be limited. As such, investors should not view it as a structural drag on asset returns. We outline four main reasons for our view:
1) QT will be much smaller than QE
The Fed’s balance sheet will not fall back to pre-crisis levels. The balance sheet expanded fivefold from USD 900bn pre-crisis to a peak in 2017 of USD 4.5trn. We believe QT will only reduce the balance sheet to about USD 3.5trn. With the reduction so much smaller than the expansion that preceded it, the direct impact of QT is likely to be significantly less than the impact of QE.
Source: Bloomberg, UBS, as of 12 February 2019
2) QT is unlikely to reverse fully the impact of QE on long-term interest rates
By buying long-term bonds and mortgage-backed securities, the Fed expected quantitative easing to push money into areas such as corporate bonds, thereby lowering corporations’ borrowing costs and, it hoped, sparking the productive use of capital. The Fed’s own research suggests that at its peak impact, QE lowered yields on 10-year US Treasuries by 100 basis points (bps), although other academic studies have disputed that the impact was this large.
QT can be expected to reverse some of this impact, but we do not expect it to raise long-term rates by 100 bps. As noted above, the reduction in the balance sheet will be far smaller than the expansion that preceded it. The evidence so far suggests that there has been no persistent trend toward a higher term premium. And, in fact, during 4Q18 when investors appeared most concerned that QT was having an adverse impact on risk assets, the term premium fell.
Source: Bloomberg, UBS, as of 6 January 2019
3) QT should not significantly impact liquidity or inflation
QT is also unlikely to have a significant impact on liquidity or inflation. Changes in liquidity or inflation conditions occur when there is a mismatch between supply of and demand for cash.
In the financial crisis, liquidity preference rose, and so central banks "printed money" in response. With the financial crisis now more than a decade behind us, the liquidity preference has fallen, and so the Fed is responding by reducing the amount of cash reserves in the system. This response, which is necessary to keep the supply of and demand for cash in balance, should therefore not affect liquidity or inflationary conditions. Indeed, ten years' worth of inflation data show that QE has not proven inflationary and, similarly, QT should not have a depressing effect on inflation. In fact, if the Fed were not reducing liquidity supply now, cash supply would exceed cash demand and inflation could become a serious problem.
Source: Bloomberg, UBS, as of 31 January 2019
4) The Fed’s balance sheet will start growing again in 2020
The Fed's quantitative tightening only started in October 2017, but we may now already be closer to the end of QT than the beginning. Uncertainty remains over both the final size of the Fed's balance sheet and the precise timetable for balance sheet normalization. Initial estimates were that balance sheet runoff might end in March 2020 with USD 1trn of excess reserves, but the Fed may bring forward the end date.
Source: Haver Analytics, UBS, January 2019
Other points to consider
Although we do not think the Fed's QT is likely to have a major direct impact on asset prices or the economy, we believe that QT by the ECB or BoJ would have a greater impact if and when they start to reduce their reinvestment of the proceeds from maturing assets or sell assets. In the Eurozone and Japan the magnitude of QE, relative to their overall economies, has been much larger, in part because both of these economies were more cash-based than the UK and the US. The ECB and the BoJ were also much bolder in the range of instruments they bought, extending into corporate bonds, and, in Japan’s case, equities.
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I'm well-versed in the realm of quantitative easing (QE) and quantitative tightening (QT). Here's the breakdown:
Quantitative Easing (QE): QE is an unconventional expansionary monetary policy employed by central banks when their policy interest rates are near zero. In this strategy, the central bank electronically creates money, using it to purchase assets, typically government bonds, from the market. The infusion of money into the financial system encourages banks to lend more, potentially lowering interest rates. This, in turn, stimulates borrowing by businesses and households, providing a boost to the economy.
Quantitative Tightening (QT): On the flip side, QT is a contractionary monetary policy, the opposite of QE. It occurs when central banks, having previously bought assets through QE, start reducing their balance sheets. The reduction in the balance sheets can happen through methods like allowing bonds to mature without replacement (passive tightening). While the Federal Reserve in the US is currently engaged in passive tightening, the Bank of England and the European Central Bank have ceased asset purchase programs but haven't actively reduced their balance sheets.
Why It Matters: Investors are apprehensive about the potential impact of quantitative tightening on markets. Over the last decade, asset returns have shown a strong correlation with central bank purchases. The fear is that as central banks unwind their balance sheets, it might significantly affect markets.
Our View: We believe that the direct impact of the Federal Reserve's quantitative tightening program is likely to be limited. Here are four key reasons:
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Size of QT: The reduction in the Fed's balance sheet is expected to be much smaller than the earlier expansion through QE, limiting the direct impact of QT.
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Long-Term Interest Rates: While QE aimed to lower long-term interest rates, QT may not fully reverse this impact, and the evidence suggests that there might not be a substantial rise in long-term rates.
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Impact on Liquidity and Inflation: QT is unlikely to have a significant impact on liquidity or inflation, as it responds to the changed conditions of reduced liquidity preference.
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Future Growth of Fed's Balance Sheet: The Fed's balance sheet, undergoing quantitative tightening since October 2017, is expected to start growing again in 2020.
It's worth noting that while the Fed's QT might not have a major direct impact on asset prices or the economy, the situation could differ for the European Central Bank (ECB) or the Bank of Japan (BoJ) when they start reducing reinvestments or selling assets due to the larger magnitude of their QE relative to their economies.
For more details, you can refer to the full report on the impact of QT on financial markets. If you have any questions or need further clarification, feel free to ask.
