From Quantitative Easing to Tightening Policies
On Tuesday 16th December 2008, following the recession, the Federal Reserve lowered its benchmark interest rate to a range of 0 – 0.25%. The central bank also implemented the Quantitative Easing, which consists in purchasing US Treasuries and mortgage-backed securities to increase liquidity and stimulate the economy with new printed money.
In December 2015, based upon a better economic backdrop, Janet Yellen as Chair of the Fed, began a tightening policy. Since then, the Fed has raised the interest rates by 25 basis points 9 times, rising from 0 – 0.25% to a range of 2.5 – 2.75% in only 3 years. Since Jerome Powell succeeded to Yellen as Chairman of the Fed, his increasing confidence in the US economy, based upon accelerating inflation and a solid economic backdrop, allowed the Fed to raise the interest rates 4 times in 2018. While the Fed had signaled it would probably raise rates twice in 2019 and twice in 2020 to finally reach 3.5-3.75% in 2020, a dovish January Fed meeting changed expectations as it seemed the central bank would be more patient than expected regarding a future rate increase.
Figure 1: Federal Reserve’s funds rates increasing over time
Source: Macro Trends
Borrowers taking cautious stances
Since the tightening policy began in December 2015, signs of rising inflation, pushed the central bank into a more hawkish direction, raising the rates by 2.25% in 3 years. A moderate rising inflation is indeed an indicator that the economy is doing well, and it paves the way for salary increases but also interest hikes. Higher rates allow a better yield for savers, but it also means consumers and business will face higher costs when they want to access credit. Even more worrying, with US incomes still relatively flat, higher interest rates mean many homeowners with flexible-rate mortgages may be unable to repay their loans. This was one of the causes for the subprime crises: people took on mortgage debt at a very low interest rate thinking they would be able to reimburse it, but when the rates increased, they found themselves with not enough liquidity to pay back their interests on debt and lost a major part of their savings. And not only…
Bond holders see their prices fall…
A tightening monetary policy is a negative news for investors who see the price of their bonds fall. Interest rates and bond prices have an inverse relationship; meaning if one goes up, the other goes down. Therefore, if the interest rates increase, the value of a bond will decrease. The reason for this is that new bonds can now be issued at a higher yield and will therefore give a higher return than the bonds which are already on the secondary market pushing the demand for the existing bonds down together with their price.
“If the Fed is buying Treasuries, investors have to go further out the risk spectrum in search of returns,” said Subadra Rajappa, head of US interest rate strategy at Société Générale. “So, if the Fed is unwinding QE then the reverse should be happening. It should be negative for credit spreads and equities”.
…and so do equity holders
It seems the market wasn’t prepared to switch to quantitative tightening as US stocks had their worst December since 1931. The S&P 500 Index fell 15.7% between December 3rd and December 24th, when it reached its lowest point of the month. The Dow Jones Industrial Average fell 15.6% entering the correction zone.
Equities usually underperform during tight monetary policy periods. The higher the interest rates, the easier for investors to find low risks investment with high yields, such as bonds. As risk appetite is restricted, equities sell-off drives stock markets prices lower. On the other hand, higher interest rates environment impacts investor confidence that the economy is growing strongly enough for the corporations to offset the impact of higher borrowing costs.
Figure 2: S&P 500 (blue) and Dow Jones (red) Indexes falling for the month of December
The impact on the Yield Curve
The Yield Curve is a graphic representation of the interest rates at different maturities for a given credit quality. The most common yield curve compares different maturities of the U.S. Treasuries. The tightening policy of the Fed controls short-term interest rates but has very little impact on the long-term. Therefore, the Fed monetary policy has a crucial impact on the Yield Curve. As shown on the graph below, as short-term interest rates rise, the spread between the short-term and long-term maturities diminishes, which causes a flattening of the yield curve over the years. Concerns rose around the flattening of the yield curve as it means investors do not expect to get a higher yield for long-term investments than for short-term investments even though long-term ones are riskier. In other words, it means investors expect an economic slowdown in the future.
Figure 3: US Treasury Yield Curve
Source : Guru Focus
The flattening Treasury yield curve has also raised concerns as it paves the way for a future inversion. An inverted yield curve is an interest rate environment in which long-term debt securities have a lower yield than short-term debt securities. It means that investors expect their return to slow down in the future, hence, an inverted yield curve has often been seen as an anticipator of a recession, as it has been historically observed twice and both times it was the case. The Fed takes into account inflation, economic growth and unemployment when voting for a rate hike, however it may also take into account the yield curve and pause hikes if it were to flatten further or possibly inverts.
Figure 4: The visual representation on the inverted and the normal yield curves
Source : Forbes
The impact on Emerging markets
Fed’s U-turn from Quantitative Easing (QE) to Quantitative Tightening (QT) is pretty significant for emerging markets (EMs).
As already said above, following the financial crisis, the Fed injected liquidity into the market aiming to ease financial conditions and borrowing costs by increasing demand for relatively safe assets. As a consequence, prices rose, and interest rates fell (this is the supposed effect of a QE).
Central banks across EMs followed suit, to allow non-financial corporations to get cheaper debt, consequently, private credit across EMs ballooned. Now that central banks are holding their current portfolios of bonds until maturity and selling the assets on their balance sheets to the market (QT), that private credit has started to shrink (Figure 5). Given that “credit creation has been the most important driver of asset prices for decades” as credit creation has pulled back, economies have tumbled.
Figure 5: Private sector credit creation started falling
Source : National Central Banks
EMs have strongly been affected by this unwinding for two main reasons:
- They binged the most on the giant pool of cheap money in the years since the crisis
- As the Fed started shrinking its balance sheet, as observable on the appendix 1, the supply of global dollars will also shrink making it more expensive. The dollar rally in 2018 worsened currency crises in the economies with large dollar-denominated debt (Appendix 2).
- Higher interest rates in US means higher returns for dollar-denominated banking accounts that increase investors’ demand for dollars consequently making the USD more expensive vs other currencies (Appendix 3).
Appendix 1: Fed’s balance sheet, showing a steep increase after the 2008 crisis and now starting to decrease
Source : Bloomberg
Appendix 2: the huge evolution of the Chinese debt in US dollars value, representative on the EMs debt trend
Source : IMF data, Tradingview representation
Appendix 3: Balance sheet roll off is supportive for the Dollar
Source : CitiFX, Bloomberg
Authors: Noa Lachkar, Greta Pontiglio
Supervisor: Lorenzo Bracco