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The Fed prepares to unwind QE: What this “once in a generation” move means for investors

21 September 2017

With the US central bank saying it will start to unwind its $4.5trn stimulus programme, FE Trustnet asks fund managers what this means for investors.

By Gary Jackson,

Editor, FE Trustnet

Investors have to start considering whether the decision to unwind the US Federal Reserve’s $4.5trn quantitative easing (QE) programme means the post-crisis bull market is now living on borrowed time, according to fund managers.

At this week’s Federal Open Market Committee (FOMC’s) meeting, it was decided that the central bank will begin reducing the huge portfolio of bonds accumulated under QE in October. It also kept interest rates at a range of 1 to 1.25 per cent, although traders are estimating a 64 per cent likelihood that they will be lifted again in December.

Fed chair Janet Yellen said the plan to unwind the QE portfolio will be carried out in a “gradual and predictable manner” and said the decision to start next month was down to the fact that “we [the Fed] feel the US economy is performing well”.

“The basic message here is US economic performance has been good; the labour market has strengthened substantially,” Yellen said during a press conference after the announcement. “The American people should feel the steps we have taken to normalise monetary policy are ones we feel are well justified given the very substantial progress we have seen in the economy.”

The Fed’s US GDP forecast

 

Source: Federal Reserve

To wind down QE, the central bank will stop reinvesting the payments it receives from the portfolio, which will shrink its size over time. The central bank will cap the amount of bonds being wound down at $6bn per month for treasuries and $4bn per month for agency bond in October through to December. This monthly cap will gradually rise to $30bn for treasuries and $20bn for agencies during 2018.

“By limiting the volume of securities that private investors will have to absorb as we reduce our holdings, the caps should guard against the outsized moves in interest rates and other potential market strains,” Yellen explained.

The dollar reacted positively to the news, with the greenback hitting a two-month high against the yen. A stronger dollar contributed to a fall in the gold price, while the stock market reaction has been more mixed with the FTSE 100 opening the session slightly down but European bourses making gains.

Russ Mould, investment director at AJ Bell, says the FOMC’s announcement leaves investors will two main questions: if the Fed’s QE programme was behind the rally in stock and bond valuations, will its withdrawal bring them back down; and what degree of interest rate hike will halt the US equity bull market?


“The merits of QE as a tool for promoting economic growth remain open to debate but the stimulus has done wonders for asset valuations and investors around the world must now face the next leg in the great monetary experiment as the US Federal Reserve finally readies itself to start shrinking its balance sheet and withdrawing QE,” he said.

“The Fed’s plan is to sterilise QE by letting its bond holdings mature and not reinvest the coupons in new holdings. The initial rate will be $10bn a month, rising in $10bn increments each quarter until the run rate reaches $50bn.

“Now that the Fed will begin to remove the stimulus pumped into the US economy from October, the slow pace of withdrawal announced in June means it would take until early 2024 to complete the process.

“If QE boosted asset valuations then it seems logical to assume its withdrawal may have the opposite effect – unless the US economy and corporate earnings again take up the slack very quickly.”

US GDP vs Fed balance sheet

 

Source: FRED, St. Louis Federal Reserve and AJ Bell estimates, assuming Fed starts to shrink its balance sheet in line with rate outlined at June meeting from October 2017

When it comes to interest rates, Mould looked over the US hiking cycles since 1973 and found that it has tended to take between eight and nine rates rise to stop a bull market. However, he noted that the interest rate level that stopped a bull market has trended downwards over that time, from a peak of 15 per cent in 1980 to 4.25 per cent in 2007.

“The trend in those peaks is lower because the world's debt pile has grown – so the global economy is now much more sensitive to even minor changes in borrowing costs,” he said. “This could negate the bull case for stocks that is based on interest rates not reaching prior cyclical peaks for a very long time, because they may not need to.”

Tom Stevenson, investment director for personal investing at Fidelity International, noted that the Fed telegraphing its plan to unwind QE is designed to avoid upsetting bond and equity markets. However, the real focus will be on how markets react over the longer term to policy normalisation.

“The trajectory of rate hikes is indicated by the so-called dot plots, which signal rate-setters’ views of future rate rises. Yesterday’s chart continues to suggest that the Fed will press ahead with one more quarter-point interest rate hike by the end of the year and three further quarter point hikes in 2018. This will provide some support for the dollar, which has weakened in 2017 on expectations for lower for longer US interest rates,” he said.


“If the Fed does pull the trigger on another hike in December, it will add to the upward pressure on bond yields (and so downward pressure on bond prices). However, structural issues – namely still high global debt, an ageing global population and rising inequality – should help to keep a lid on yields and so support bond prices.”

However, Architas investment director Adrian Lowcock is not quite as optimistic.

He argued that the move will have a significant impact for anyone holding bonds in their portfolio and said investors should not think of this as a US-only issue as it is indicative of much wider trend for tighter monetary policy.

“This is a key step on the way to more global monetary tightening. The ECB [European Central Bank] is expected to announce tapering of their QE programme which will contribute to the pressure on bonds with yields expected to rise and prices to fall,” he said.

“The significance of the announcement, whilst expected, should not be under appreciated. This is a once in a generation change. Over the past decade we have become used to central banks buying bonds each and every day.

“That has now changed and when the programme gets up to speed the Fed will be reducing its balance sheet by $600bn a year. This matters to investors in bonds as it affects how you invest in them and the returns you can expect to get from that asset class in the future.”

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