Credit investors nervous over withdrawal of QE2

The much-anticipated end of quantitative easing in the US is giving rise to fears over the economic and financial fallout when the central bank’s life support machine is turned off

Fed chairman Ben Bernanke

In November 2008, the US Federal Reserve began a purchasing programme that brought around $600 billion of mortgage-backed securities onto its books. By June 2010 the Fed’s accumulation of bank debt, MBS and Treasury notes amounted to $2.1 trillion (including the $700–$800 billion it already had on its balance sheet before the crisis). It began a second round of easing, known as QE2, in November 2010 and had purchased a further $600 billion of Treasury Securities by the end of March 2011.

As those buying programmes recede, the government moves away from centre stage. That could mean one of two things, say observers. Either new actors will need to appear who can play the leading role in driving US economic growth. Or else the role of quantitative easing will have proved to be tangential to the main growth story, and its winding down will have only marginal effects on the US outlook.

“QE2’s effects have been relatively negligible,” says Stephen Mihm, associate professor of economics at the University of Georgia in the US. “It depressed long-term interest rates and there was big growth in excess reserves as a consequence of QE2 but it did not have a big effect. But if you listen to the political discourse you would think it was the second coming of Satan that QE2 had prevented.”

Hoarding the gold

Few investors believe that the US quantitative easing programmes have had a decisive impact on the trajectory of the US recovery or even on bond yields. Instead, in the risk-off environment that followed the global financial crisis, the key beneficiaries of quantitative easing actually chose to keep much of the money out of circulation.

“Banks have not increased lending nor have they added dramatically to their holdings of securities,” says John Greenwood, chief economist at Invesco in London. “QE2 was in essence a kind of subsidy to the banks but since banks are reluctant to lend and households are reluctant to borrow, we are not seeing any significant increase to liquidity at large.”

Quantitative easing programmes are designed to provide institutional investors with the cushion they need to buy up more risky assets and therefore to restore the pre-crisis levels of risk-taking needed for confidence to return. But investors may head for equities not bonds.

“The QE programme was supportive for all risky assets, including credit, equity and emerging markets,” says Robert McAdie, global head of credit research and strategy at BNP Paribas in London. “But there was a particularly strong correlation between QE2 and the rally in equity prices.”

“The ending of QE2 will be more negative for the equity market than for fixed income. The credit market is still on a sound footing and the US economy is in a gradual improvement phase. There will be greater dispersion in high yield overall, driven by weaker earnings especially for the small-cap domestic cyclical names. But I am not that concerned about the impact the end of QE2 will have on investment grade credit and on financials,” adds McAdie.

Indeed, McAdie sees four reasons to expect increased inflows to bond markets in the post-QE environment. First, the US economic outlook will hold down Treasury yields, driving investors to corporate bonds. Second, new regulatory regimes will oblige banks to increase Treasury holdings. Third, the US’s ageing population means pension funds and insurance companies (the latter also pushed by Solvency II regulation) are looking for income-generating product, and especially product with a yield premium. Finally, with concerns over inflation and political instability rising in emerging markets, some flight to quality is inevitable, supporting Treasuries further.

But some foresee a bit of slackening in Treasury yields as 2011 trundles on, albeit only a slight one. “The environment is going to be a bit less Treasury-supportive after the Fed stops buying and we move towards autumn,” says Robert Tipp, chief investment strategist at Pramerica in Newark, New Jersey. “Having said that, demand remains strong. Our yield curve is very steep, remains very attractive to foreign investors and the domestic investor is very favourably disposed to fixed income, whether mutual funds, pension funds or even bank portfolio investors.”

Moreover, there are other reasons investors are doubtful that the Fed retreat will have the sizeable impact often prophesied. It is not just there are still plenty of investors looking for Treasury product, but the retreat from more risky products has already begun, and for reasons that have a far greater impact on bond markets than the long-expected wind-down of QE2.

next

Credit investors nervous over withdrawal of QE2

page 2