What next after QE?

As the end of quantitative easing approaches, experts offer their views on its impact and how its unwinding might impact bond and equity markets
by Paul Golden

Jargon buster

Government bond
A debt obligation issued by a national government to support state spending which usually pays periodic interest and repays the face value on maturity (also known as a gilt).

Corporate bond
A debt security used by companies to raise funds where the investor receives interest payments and their initial investment is returned when the bond matures.

A rating that signifies a bond presents a relatively low risk of default.

Yield curve
A line that plots yields (interest rates) of bonds with equal credit quality but differing maturity dates.

Bank rate
The interest rate the Bank of England pays to commercial banks that hold money with it, which influences the rates those banks charge people to borrow money or pay on their savings.

On 2 February 2022, the Bank of England’s Monetary Policy Committee (MPC) voted unanimously for the Bank to begin to reduce its stock of UK government bond purchases and sterling non-financial investment-grade corporate bond purchases by “ceasing to reinvest maturing assets” for both and “by a programme of corporate bond sales” for the latter.

The minutes say that the MPC will “consider beginning the process of actively selling UK government bonds only once the Bank rate has risen to at least 1% and depending on economic circumstances at the time”. And the stock of corporate bond purchases should be fully unwound by the end of 2023.

These decisions mark the start of the unwinding of quantitative easing (QE) in the UK, a programme of bond purchasing that started in the aftermath of the 2008 global financial crisis, when the Bank decided that very low interest rates alone would not be enough to boost the economy.

The Bank began buying bonds through QE in March 2009 and by November 2009 its purchases stood at £200bn. In order to meet its inflation target that figure was increased to £375bn by July 2012.

The next factor to impact QE was Brexit, with the Bank raising its bond stocks to £445bn in August 2016 to boost the economy in the wake of the EU referendum.

But the biggest single influence on QE policy has been the pandemic, which prompted the Bank to more than double its bond purchasing programme to £895bn by November 2020.

Under QE, the Bank bought UK government bonds and corporate bonds, which increased their prices and reduced the bond yield or ‘interest rate’ received by holders. The reasoning was that this lower interest rate would feed through to lower interest rates on personal and business loans, boosting consumer and corporate spending.

An effective strategy?

To determine the effectiveness of the QE programme, the UK’s Economic Affairs Committee launched in 2021 an inquiry into QE, publishing several key findings, including that “QE has been effective at stabilising financial markets during periods of economic turmoil”, but that “it has had only limited impact on growth and aggregate demand over the last decade”, and that “there is little evidence to show that QE increased bank lending, investment, or that it had increased consumer spending by asset holders”.

Andrew Sentance CBE, a senior adviser at Cambridge Econometrics and former member of the MPC, suggests that the UK would not be far away from where it is now in terms of interest rates if it had not introduced the bond purchase programme. “There is a view among many economists that subsequent rounds of bond purchasing – coupled with low interest rates – have held back the long-term growth of the economy and that we might actually have been better off without it,” he says.

The MPC has not committed itself to selling UK government bonds as soon as the bank rate reaches 1%. According to Andrew, it is hard to say what the optimum approach to unwinding QE is because no country has ever been through a similar process before.

If UK unemployment rates remain stable and the housing market is not at risk of an increase in delinquencies, conditions for a bond sale would be relatively favourable. 

There is a view that QE has held back the long-term growth of the economy

But ING senior rates strategist Antoine Bouvet has misgivings about the Bank of England’s plans to go ahead with active bond sales because of its possible impact on market liquidity. “When active balance sheet reduction starts, we will have the Debt Management Office and the Bank of England competing for demand for gilts,” says Antoine. “In times of acute market volatility like now, I think this risks keeping some investors away from the gilt market or at the very least worsening market volatility.”

The US is also now starting to unwind its own QE, which it launched in 2008 in an attempt to lower long-term interest rates and stimulate the economy. In November 2021, the Federal Reserve’s Federal Open Market Committee (FOMC) decided to begin reducing the monthly pace of its net asset purchases by US$10bn for treasury securities and US$5bn for agency mortgage-backed securities. These two figures were doubled the following month.

Jean Luc Proutat, head of OECD economies at BNP Paribas, reckons QE has played a key role in enabling the US economy to return to pre-pandemic levels and achieve almost full employment. “[However] this monetary hyper-stimulation [has also] contributed to reviving inflation,” he says.

Maria Solovieva and James Marple from Canadian analytics firm TD Economics suggest QE’s impact was most significant during the initial lockdown phase of the pandemic as it was a clear market signal that injected calm, order and liquidity into the treasury market. But they also acknowledge that the magnitude of the impact of QE on yields is uncertain.

According to Morningstar analysts Sandy Ward and Lauren Solberg, markets expect the Fed’s quantitative easing to be followed by quantitative tightening (opposite of QE, shrinking the central bank’s balance sheet assets) by June this year.

"The Bank is acutely aware of the distress that rising long rates causes for debtors"

The question of when to start quantitative tightening relative to increases in the bank rate has been debated for some time. “Quantitative tightening will tend to raise longer-term rates and the Bank is acutely aware of the distress that rising long rates causes for debtors and particularly the biggest debtor – the government,” explains John Whittaker, senior teaching fellow at Lancaster University Management School.

For that reason, the Bank may be more hesitant to start tightening, although higher bank rates also push up long rates through expectations of future rate rises.

Finding the right approach

The swelling of the Bank's QE programme during the pandemic coincided with the core base rate reaching an all-time low of 0.1% in March 2020 (and staying at that level until December 2021). Judging that further stimulus was required, but with a reluctance to reduce the bank rate below zero, the Bank’s asset purchases helped to put further downward pressure on lending rates throughout the economy.

“The combination of these two arms of monetary policy is likely to have pushed up asset prices both nationally and internationally, including providing a strong boost to house prices,” says Josie Dent, managing economist at the Centre for Economics and Business Research (CEBR).

Letting bonds mature will minimise market impact Despite Andrew Sentence’s criticism of the bond purchase programme and a suggestion that the Bank has not conducted sufficiently rigorous analysis of the options for unwinding it, he accepts that allowing maturing bonds to run off is a common sense, practical approach. “It would be great to be able to move interest rates to a more normal level immediately, but that is not possible. A gradual approach will enable the markets to absorb what the Bank is doing.”

But Andrew also suggests that if the Bank had adopted this approach earlier, the bond purchase programme could have been sitting at around £600bn by now. “Quantitative easing positions have been allowed to accumulate and interest rates have been allowed to remain too low for too long,” he says.

Gregory Perdon, Chartered FCSI, co-chief investment officer at Arbuthnot Latham, is another who doesn’t expect the Bank to engage in direct asset transfers (or crossing) to long-term bond holders. “I don’t believe the Bank is in any rush to shrink the balance sheet, but I do believe it will increase rates pretty consistently this year,” he says. “The strategy of letting bonds mature and roll off will minimise market impact.”

The Bank’s approach will also be dictated by how quickly it wants to reduce its UK government bond holdings. John Whittaker says that with the average maturity of gilts being 14 years, a passive approach of simply letting these bonds mature would require 7 years for the Bank’s holdings to fall by half.

Bryn Jones ACSI, fixed income fund manager at Rathbones, says a possible approach to actively selling these government bonds would be for the Bank to set up pre-announced auctions of bonds in its portfolio, with sizing proportional to its holdings in each maturity bucket (the most recent purchases were split into 3–7 years, 7–20 years and 20-plus years). “However, it may also wish to consider which sales would minimise interference with the Debt Management Office’s issuance programme,” he adds.

Institute of Economic Affairs fellow Julian Jessop is more sanguine. He reckons there is no need for a mechanism for transferring these assets to natural long-term bond holders and that the Bank should just auction them off to whoever wants them (and is willing to pay the highest price). “What happens to credit spreads will largely depend on developments in the real economy and investor risk appetite,” he adds.

Bond and equities impact

When asked how unwinding QE might impact bond and equity markets, Neil Brown, Chartered FCSI, chair of the CISI’s Bond Forum, says rates should steadily rise at the long end of the market because a significant buyer has disappeared. However, there will still be institutional demand for long-dated fixed income from pension funds and other institutional investors with long-term liabilities.

“The overall effect on these markets depends on other factors, such as whether inflation stabilises at a higher-than-expected rate,” he says. “If inflation ticks down, we could expect to see just a slightly weaker bond market and a continuation of modest growth in equities.”

The extent to which the sale of government bonds affects interest rates and credit spreads will depend on the conditions at the time of the sale, agrees Gregory Perdon. “Credit spreads are tight because of high liquidity in markets, strong economic growth, favourable credit conditions and the perception that defaults will not rise in the short term as mobility increases and we return to ‘normal’,” he says.

Credit spreads could widen due to higher risk premia and less of an imperative amongst investors to search for yield, suggests Whittaker. “Corporate borrowers may be deterred by higher rates, although I don’t subscribe to the textbook idea of ‘crowding out’ that seems to assume a fixed pot of funds for investment where more government debt would leave less available for corporates,” he adds.

Policy shifts

With fiscal policy already being tightened in many countries, the bulk of the counter-inflationary policy tightening in the UK over the coming year is likely to reflect higher interest rates and the rolling back of QE.

Josie Dent says the CEBR sees both policies – but especially QE – operating mainly through the asset markets. “Based on strong market responses to expectations of policy changes over recent months, we have a hunch that the scale of the policy adjustment might not need to be too great because there will be a significant asset market response,” she says. “This means we are expecting bond, equity and property markets around the world to fall by between 10% and 25%.” She adds that the timing of these market corrections will also vary, with some of the impact falling into 2023.

Whatever approach the Bank of England takes to unwinding QE, it will be crucial that it is clearly communicated and predictable. Rathbones expects quantitative tightening to put upward pressure on longer dated gilt yields and as such steepen the curve to a degree, according to Stuart Chilvers, Chartered MCSI [winner of the CISI Chartered Wealth Manager award in 2017], a fixed income fund manager at the firm.

“In terms of credit spread impact, corporate bonds sales are likely to have a more material impact as we saw with spreads widening significantly following the announcement from the MPC, although the intention is for the programme to be designed so as to not disrupt the functioning of the sterling credit market,” he concludes.

Seen a blog, news story or discussion online that you think might interest CISI members? Email fred.heritage@wardour.co.uk.
Published: 01 Apr 2022
  • Bonds
  • Corporate finance
  • Wealth Management
  • Risk
  • quantitative tightening
  • quantitative easing
  • QE
  • Covid-19
  • Brexit
  • Bank of England

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