How Quantitative Easing Will Affect Bond, Currency and Related ETFs

By Paul Amery

If you've opened a Financial Times or a Wall Street Journal lately, you've probably encountered the term "quantitative easing."

First practised by the Japanese central bank in 2001-2006, this radical step in monetary management has now been taken in the last few months by the US Federal Reserve, the Bank of England, and the Swiss central bank, while the Bank of Canada prepares to join in. Of the world's major central banks, only the Frankfurt-based ECB is so far sitting on the sidelines, preferring to use more traditional means of monetary policy.

What exactly is quantitative easing ("QE"), and how will it affect investors in different categories of ETFs?

QE is a policy step undertaken by central banks when they become concerned that interest rate cuts may not be working, or when rates are already at such a low level that further cuts are effectively impossible. The rationale for the policy was set out in a 2004 speech by the current US Federal Reserve Chairman Ben Bernanke, perhaps the chief ideologue for the QE movement.

Bernanke said:

"The public might interpret a zero instrument rate as evidence that the central bank has ‘run out of ammunition'....[T]hat would be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate... [P]olicymakers are well advised to act pre-emptively and aggressively to avoid facing the complications raised by the zero lower bound."

QE involves the central bank buying assets from private banks. Usually, the bank will focus its purchases on government and corporate bonds, but it can in theory buy anything, even equities. This transfers money to the banks' balance sheets. The intention is for the central bank to resell these assets at some point in the future, but there is no fixed date for this to occur.

'Money Multiplier'

The newly-created money—base money, in economics parlance—is supposed to help stimulate lending in the economy through the effect of the "money multiplier": since banks are typically required to keep the level of overall loans at a minimum fixed multiple of their reserve assets, the more reserve assets they have, the more they can lend.

It's fair to say that the ultimate outcome of the QE experiment is highly uncertain. Even the results in Japan, which started it eight years ago, are still hotly debated. Many argue that QE had little discernable effect in helping the Japanese economy recover; Western policymakers counter that Japan adopted QE too late in its downturn to have the desired results.

This explains the prompt and coordinated introduction of the policy in recent months, occurring very soon after interest rates had been slashed, a tactic that was clearly flagged in Bernanke's speech.

The most vocal critics of QE argue that, in an economy suffering from excessive debt levels, where market participants want to reduce their indebtedness, QE will be ineffective, as no one will want to borrow all the newly-created money.

In addition, the introduction of the policy threatens the world's central banks with possible losses from their market operations, which will have to be met by the taxpayer. QE also places the central bank in a more active fiscal (and therefore political role), something with major implications for the balance of power between policymaking institutions.

These reservations aside, it's fair to say that the consensus amongst economists is that QE will help the economy to recover, and there have already been some sharp moves in markets as a result of its introduction. How have these been reflected in some key exchange-traded fund sectors, and what is the likely future impact on prices from QE?

Bond ETFs

As the initial assets to be bought under a QE policy are usually government bonds, ETFs tracking state debt in the countries concerned rallied sharply on the news of its introduction.

When the Federal Open Market Committee announced on March 18 that it would spend over a trillion dollars to buy government and agency debt, prices soared, with the 10-year Treasury bond falling half a percent in yield.

In the UK, a similar yield move in the gilt market followed the Bank of England's buyback plans, announced on March 5.

It's worth noting that, in both markets, prices and yields (which, for bonds, move in inverse directions) have retraced some of their initial move. For example, the iShares FTSE UK All Stocks Gilt ETF (Yahoo Finance: IGLT.L), which opened at a price of £10.01 on March 4, the day before the QE announcement, soared to close at £10.84 on March 6, the day after. At the close on Friday 27 March, the ETF's price had fallen back to £10.58.

Similarly, the 10-year US Treasury yield, which fell from 3% to 2.5% on March 18, ended Friday March 27 at 2.7%.

Where do prices (and yields) go from here? Some market historians have noted that, during World War II and for several years afterwards, the US central bank agreed to purchase unlimited amounts of government bonds from banks to keep interest rates low, capping yields at 2.5% throughout the 1940s. It may well be that central banks in the QE countries intend to follow a similar course of action now, not least because, again, Federal Reserve Chairman Bernanke has talked openly about doing this.

If central banks could achieve this outcome, government bond ETF owners would be faced with a new world (to those of us who weren't around then)—fixed and very low rates of return, but with a government floor under bond prices. Most of the investment risk would come from currency movements (more on this below).

Perverse Consequences

It's worth pointing out some perverse consequences from the initial QE moves. First, in the UK at least, the 10-year breakeven inflation rate between conventional (fixed-rate) bonds and index-linked (inflation-protected) gilts has actually moved lower since March 4, as central bank buying has pushed fixed-rate bond yields down, while index-linked yields remained relatively unchanged.

As QE is intended to prevent deflationary expectations setting in, so far UK policymakers seem to have achieved the opposite. Since the Bank of England has made index-linked gilts look relatively cheaper than a month ago, buyers are taking advantage; Alex Claringbull, senior fixed income portfolio manager at iShares, told me that his firm sees steady investor interest in inflation-linked bond ETFs.

Another consequence of QE-related gilt purchases has been to reduce demand for those maturities not included in the Bank of England's targeted gilt range (which are bonds with 5-25 years to redemption)—something evidenced in last week's failure of a 40-year gilt auction.

Finally, pension experts have pointed out that a policy of pushing down long-term interest rates will worsen the deficits in final-salary (defined benefit) pension schemes, which are already at a record. In other words, company finances could deteriorate still further as a result of the need to pay in further contributions.

The implications of QE for corporate debt are a little less clear. While central banks in the countries concerned would clearly like to push the credit spread between corporate and government bond yields lower, the scope for direct intervention in the corporate bond markets is more limited, not least because company debt is less liquid, and because the assets would be riskier and therefore much more likely to incur a loss. While the Bank of England has specifically authorised such a move under its QE programme, the effect remains to be seen.

Currency ETFs

One immediate result of QE announcements has been to push the currencies of all the countries involved sharply lower. The US dollar index fell 4.1% in the week of Bernanke's FOMC statement, the biggest weekly decline since 1985. Against the euro, the dollar weakened by over ten "big figures" in little more than a week, from 1.2650 to over 1.3650, though the US currency has strengthened a little since then.

Some commentators have observed that quantitative easing can allow competitive currency devaluation against your neighbours, something, incidentally, that wrecked international economic cooperation in the 1930s. There are sure to be discussions on this subject at the G20 event just beginning in London, though whether these will lead to any statements on currency policy remains to be seen.

In any case, those ETF investors with foreign currency exposure in a country committing to QE may wish to hedge it to avoid losses.

Commodity ETFs

The flipside of currency devaluations has, unsurprisingly, been a resurgence of investor interest in some "hard" assets. Gold rocketed almost $60 per ounce in price on March 18, from $890 to just short of $950. Meanwhile, the oil price has continued to rally from its recent lows.

The healthy state of investor demand for commodities is shown by the continuing inflows to tracker products like ETF Securities' ETCs. Assets under management at the firm recently rose above US$ 10 billion for the first time since the commodity price peak last summer.

While the outlook for commodity prices in general depends on many more factors than quantitative easing policies, demand for the monetary metals—gold and silver—seems well-underpinned by the latest central bank interventions.

Equity ETFs

The impact of QE on equity prices is perhaps the hardest to assess. The main short-term effect so far has been on bank shares, which have rebounded sharply in recent weeks. This, of course, may also be due to the impact of the recently-announced "PPIP" scheme in the US, which promises to relieve banks of some of their bad debts. The KBW bank share index in the US rose 75% from its early March low to last week's high, while in Europe the DJStoxx 600 banks index climbed by nearly half.

If QE were to have the desired effect of improving credit conditions and stimulating lending, one could expect equities to benefit the most. Any QE-related decline in bond yields would also make equity yields look attractive by comparison—with the caveat that yield levels (i.e. company dividends) would need to be maintained.

The only historical case we have to go on, the Japanese QE experiment, does not give us a clear answer. When quantitative easing was introduced in March 2001, the benchmark Nikkei 225 index was at 13,000. It fell to below 8,000 two years later, then rose to around 17,000 in March 2006, when the QE policy was discontinued (incidentally, the Japanese authorities have recently restarted it). Although QE led to a seven-fold increase between 2001-06 in base money—commercial bank reserves at the central bank - some observers have argued that Japanese share price changes owed more to global market conditions than anything else, since domestic economic growth in Japan remained elusive.

Summary

The clearest follow-on effect of quantitative easing policies is likely to be seen in the government debt and currency markets.

Governments may well manage to peg or cap bond yields for a sustained period. At the same time they are increasing the risk of currency devaluation, and they are also likely to increase currency volatility.

Gold and silver investment demand is likely to stay strong while such policies continue.

And the effect on equities is unclear, as it's uncertain whether QE policies will revive the growth on which share prices depend.

Original Post

Comments

[Clamdigger]

Thanks for an excellent analysis of QE and impact on various asset classes. I'm liking EWA, EWC, EWZ as hard asset-based economies less likely to debase their currencies. GLD, SLV attractive but also subject to central bank manipulation. What about TBT as a longer term hedge vs reflation?

2009 Apr 01 11:12 AM

[The Geoffster]

Japan's "lost decade" and QE produced little inflation. I would be interested to read an analysis of the inflationary effects of QE on the US economy. Did Japan's current account surplus protect it from massive inflation/stagflation? Might our CA deficit exacerbate US inflation? How do we play this and when?

2009 Apr 01 08:13 PM