Mohamed El-Erian in the Financial Times today puts forward again the argument that quantitative easing has generated little benefit and is now creating unnecessary volatility in financial markets. He presents the current monetary policy stance and the potential exit strategy as a unique experience that is generating distortions and volatility in financial markets that we have never seen before.
He uses two very simple examples of how bond returns are becoming volatile as interest rates start moving up. The logic is simple and well understood by anyone who understands bond markets: a fixed-rate bond that was issued yesterday will see its price change if interest rates move (in an unexpected manner) over the horizon over which the bond is outstanding. Here is a quote from his article:
"As a simple illustration, consider the 5-year US Treasury note issued at the end of March. A low coupon and relatively modest yield curve roll-down meant the most investors could reasonably expect at issuance was a total return of 2.7 per cent over the subsequent two-year period. If, however, five-year rates were to go up by 70 basis points, which in fact they did over the next three months, the bond was already 3.25 per cent under water (as of the June 25 close), altering the risk/return outlook."
Correct. Bonds that were issued in March under the assumption that interest rates will remain low over the next five years now look like a poor investment because the market today is looking at a scenario of higher interest rates. Without debating on whether the market is right or wrong, this is something that is standard in bond markets. News on future interest rates will cause volatility on bond prices. By reading the article, one gets the impression that the current volatility is unusual and that it is the fault of the zero interest rate policy of central banks and quantitative easing. Quoting from the article:
"This dynamic was exaggerated when securities were artificially compressed by experimental central bank policy."