Since the advent of the financial crisis, we have all heard of the term quantitative easing being thrown around by the financial media and the policy makers aplenty. In this article I will discuss what exactly this term means, how is it used as a monetary policy tool by the central bankers and more importantly its effectiveness in spurring economic growth.
Quantitative easing is an unconventional monetary tool whereby the central bankers look to support risky assets and promote investment. This is done in two ways, either by the direct purchase of risky assets like stocks as I saw China do during the Asian crisis of 1998. In that case China started buying Hong Kong listed equities to support the stock market directly.
The other way is more subtle and it involves removing interest bearing securities from the market. This is implemented by purchasing short as well as long term government bonds, which in turn results in lowering the supply of those bonds and lowers their yields. This has two effects; one it lowers the borrowing costs and second, it forces investors to seek other riskier assets that provide a larger yield.
In recent years as the central bankers have reduced short term rates close to zero, they have had to resort to quantitative easing measures to further stoke economic growth. But the question is how effective has quantitative easing been in the past and how effective can be going forward with yields already so low on government bonds.
And this where the law of diminishing marginal returns kicks in. Whether it is because financial markets are less responsive every time the bond-buying bazooka is pulled out or whether the downward drift of bond yields over time simply reduces the scope for QE to have an effect on yields is hard to say.
As I mentioned before the largest effect of bond purchases is a lowering of interest rates. The way in which interest rates affect most people is through their mortgage. In the US, mortgage rates are linked to the 10 year or the 30 year government bond rate. I say linked, because it is not a direct relationship between the two. The mortgage rate also has a component of credit spread and as government bond rates fall, that credit risk component becomes more and more significant. Here is an example to better understand this concept:
30 year Treasury rate: 5.00%
Credit Spread: 3.00%
Mortgage rate: 8.00%
30 year Treasury rate's effect on the mortgage rate = 5.0%/8.0% = 63%
30 year Treasury rate: 2.50%
Credit Spread: 3.00%
Mortgage rate: 5.50%
Credit spread component of the mortgage rate = 2.5%/5.5% = 45%
The above example shows that as the 30 year government bond rate dropped from 5% to 2.5%, its effect on the mortgage rate fell from 63% to 45%. This shows that as central bankers undertake quantitative easing, its effectiveness keeps decreasing over time with falling bond yields.
The main reason cited by central bankers for undertaking quantitative easing is lowering borrowing costs, but the flip side of that coin is that lower interest rates act as a tax on the savers. As every single savings account holder can attest to, the yields on savings accounts for all intents and purposes is zero. This means that the retirees and even the working class people have lost a significant part of their income, which does not help in promoting consumption and economic growth.
Therefore, from this point forward I would be very skeptical of the effects of any further quantitative easing on economic growth. So the next logical step for the central bankers will be to resort to fiscal stimulus. But this will be difficult from a legislative perspective as the governments around the world are on a fiscal austerity path and further fiscal stimulus would result in increasing fiscal deficits. So while I do believe that the governments will adopt more fiscal stimulus measures, in the short term the markets will suffer.
Pretty much in line with the past 2 years, I expect the equity markets to come under pressure in August and September resulting in money leaving the risk assets and going to the safety of bonds and the US Dollar. This could see the 10yr yields in the US drop to 1.25% and the EUR/USD to 1.15.
After that it is likely that announcements of fiscal stimulus result in a risk rally. At that point I would expect Gold and equities to rally and the US Dollar to suffer the most.