Brace yourselves for the post-QE era
Many have stopped using the 2008 global financial crisis as the starting point for assessing the performance of asset prices, and are looking at price action since Trump’s victory instead
“Inflection point” is an abused and overused term in financial markets.
Yet it is no exaggeration to say that central banks’ exit from the ultra-loose monetary policies they have been pursuing for the last several years represents one of the most significant, and perilous, moments in the history of financial markets.
This is, quite simply, the mother of all inflection points.
To be sure, the exit has only just begun and is being mitigated by what are still extremely accommodative financial conditions, underpinned by the quantitative easing (QE) programmes of the European Central Bank (ECB) and the Bank of Japan (BoJ) which are helping suppress bond yields.
According to a report from JPMorgan published on December 1, the stock of negative-yielding government bonds still amounts to some $9 trillion. The share of sub-zero-yielding sovereign debt in JPMorgan’s benchmark developed market government bond index (GBI-DM) stands at 20 per cent.
Yet this is already down from a peak of 32 per cent in July.
Make no mistake, the “lower for longer” period of global interest rates has finally come to an end.
The only question is how painful and disorderly the monetary policy normalisation process is likely to be. The last two months of 2016 provided a glimpse of what the post-QE era could look like.
The US Federal Reserve is at the forefront of a much-discussed shift from monetary easing to fiscal expansion as the main source of stimulus for the global economy.
The Fed’s decision on December 14 to announce a faster-than-anticipated pace of monetary tightening next year, partly as a pre-emptive move in anticipation of the reflationary economic policies of president-elect Donald Trump, has fuelled a sell-off in the bond market.
The yield on benchmark US 10-year Treasury bonds has shot up 65 basis points since Trump’s victory to 2.5 per cent, its highest level since September 2014. Its 2-year equivalent, meanwhile, has surged 40 basis points to 1.2 per cent, its highest level since the end of 2009.
While the rise in European and Japanese bond yields has been much less pronounced, even the BoJ and the ECB have moved away from unlimited asset purchases and are now focusing on managing the yield curve for short and long-term borrowing costs and improving the transmission mechanism of monetary policy.
Although there is a significant divergence of views among investment strategists about where yields are heading, a regime change in financial markets is in the air – so much so that many market commentators have suddenly stopped using the 2008 global financial crisis as the starting point for assessing the performance of asset prices, and are instead looking at price action since Trump’s victory in the US election.
The “Trumpflation” trade – a repositioning of investors’ portfolios favouring equities over bonds - is the prologue of the post-QE policy regime.
International investors must now prepare themselves for the first chapter.
From a market sentiment standpoint, the stakes could not be higher.
Central banks’ ultra-accommodative monetary policies have distorted asset prices and desensitised investors to risks and vulnerabilities in the global economy.
Markets have become used to central banks being, in the words of Mohamed El-Erian, chief economic adviser to Allianz, “the only game in town”.
The exit from seven years of QE, which has only just begun, is bound to be a tumultuous one, particularly if Trump’s reflationary policies – now perceived by investors as the substitute for further monetary stimulus – are not as aggressive and effective as is currently being priced in.
Even if Trump, who takes office on January 20, is able to get a hefty fiscal stimulus package approved by Congress, global equity markets – which have rallied spectacularly since the US election in anticipation of stronger growth – could start to wobble because of concerns about an even more hawkish Fed.
Emerging markets (EM) will be particularly vulnerable as the post-QE era unfolds.
The sharp deterioration in sentiment towards developing economies in the last two months of 2016 – EM equity and bond funds experienced six consecutive weeks of outflows following Trump’s victory – shows the extent to which the asset class suffers when central bank-driven volatility picks up.
The world’s leading central banks used to have a stabilising effect on markets. In the coming years, they will be a source of intense volatility.
Nicholas Spiro is partner of Lauressa Advisory