Restricting the spread of coronavirus has disrupted the entire economy. With businesses unable to trade, the government launched a series of stimulus packages to shore up the economy and maintain social cohesion.
The cost of this was met by the government creating more money, by issuing debt. Raising cash at a time of great uncertainty can be risky, so quantitative easing (QE) was used to support the project.
QE is throwing money at the problem
Central banks use QE to create money by buying government-issued bonds from banks and other investors, generating cash to be pumped back into the economy.
There is nothing new about it. When the banks began feeling the pinch caused by bad debts as the credit crunch became the financial crash in 2008, the Bank of England stepped in to smooth things out.
The cost of keeping banks open and protecting consumers rose to £445 billion by August 2016. In the past year, QE has more than doubled this figure to £895 billion by November 2020.
We’re all in it together
The UK is in good company when it comes to the application of QE. The US Federal Reserve, European Central Bank and Bank of Japan increased their balance sheets by $8 trillion in 2020. However, quite apart from having to pay back the debt, QE comes at a cost, by making all assets, not just bonds, more expensive.
“With central banks buying massive amounts of government, or in some cases, corporate bonds, some investors can no longer just hold on to bonds and are forced to look at other, riskier assets,” says Celene Lee, principal and investment consultant at Buck.
An increase in demand for government bonds, pushes up their price, but reduces the returns on those bonds. The amount repaid to the purchaser over the time it is held is the yield and typically yield curves would increase as durations increase. But QE not only lowers the curve, reducing yields on all bonds, but flattens it, so that longer-duration bond yields resemble those of shorter duration.
QE makes all assets more expensive
The return on government bonds is usually referred to as the “risk-free rate” and is the benchmark other asset classes are generally measured against when it comes to risk.
“When you start to move away from that to credit, corporate bonds for example, you’re taking on additional risk,” says Chris Iggo, chief investment officer at AXA Investment Managers.
I’m more worried about stimulus being pulled back too soon, rather than too late. We haven’t finished this crisis yet
“Normally you’re compensated by getting higher yield, but that difference has been reduced. And so investors have been driven into riskier asset classes to get the yield they need for their objectives.”
Risk is not a bad thing, provided you can afford it. The search for returns has resulted in booming equity markets and it is government intervention that has boosted investor confidence.
“These measures have been largely responsible for driving the recovery of markets, most of which have returned to, and in some cases surpassed, their pre-crash peaks from early last year,” says Maike Currie, investment director at Fidelity International. “The steps taken early on provided investors with much-needed confidence following swings in volatility.”
Growth will also have a positive impact upon some markets, such as commodities, driving up the price of oil and other important materials. These markets have been suppressed while economies were in lockdown.
Avoiding a temper tantrum
Melanie Baker, senior economist at Royal London Asset Management, says the “swift policy action” limited the “short and long-term damage to the economy” that would have been caused had central banks not intervened.
Concerns that asset price inflation will lead to broader inflation in the economy – one of the key responsibilities of central banks – are valid, but premature.
“I’m more worried about stimulus being pulled back too soon, rather than too late,” says Baker. “We haven’t finished this crisis and though we can see some light at the end of the tunnel with vaccines, we’re not there yet.”
In 2013, the Federal Reserve announced it would reduce its QE programme, leading to a panic that the markets would fail due to a lack of liquidity.
This event was referred to as the “taper tantrum”, but there is a danger investors become used to QE as the norm, with any reduction in the supply being met with violent reactions, much like a drug addict going cold turkey.
The future is bright and may be green
Despite concerns about the medium-term effect on investment markets from the influence of QE, increased demand for policies to combat climate change presents attractive opportunities for investors.
“ESG [environmental, social and governance issues] and energy transition provide the potential for a kind of longer-term economic expansion that could be equivalent to a kind of fourth industrial revolution, where returns may be supercharged because of all these new investment opportunities,” says Iggo.
Reversing the communication breakdown
As Baker points out, it is too soon to say how governments will begin to unwind QE. But one thing the government and central banks can do now, says Iggo, is to improve their communication on the economy and their strategies to manage it.
“There needs to be more clarity and it’s the same with fiscal policy, which simply confuses people,” he says.
There are those in government, says Iggo, who want to see spending cut and taxes raised as soon as possible. This may not be appropriate when they want to see it done and the mixed messages of opinions and policy confuse everyone and reduce confidence.
How governments manage their QE policies is likely to become a yardstick for their overall performance. This is because QE is here for the foreseeable future and will not be reversed during the term of this administration or even, perhaps, under a number of future governments.
