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How the ECB’s and BoJ’s QEs are remodelling the fixed-income markets

THE ESSENTIAL

Although the BoJ conducted a form of QE in the early 2000s, market players generally credit the Fed with launching the QE trend when it intervened heavily in the markets in the wake of the Great Recession. Nonetheless, there is some evidence that the impact of the QE programmes conducted by the ECB and BoJ has been more consequential than that of the Fed on the global bond markets.

The QE programmes conducted by the ECB and BoJ have had a powerful impact on their bond markets, a trend amplifi ed by the introduction of negative interest rates. One of the most remarkable consequences of the low bond yields caused by the policies of the ECB and BoJ is that investors’ search for yield has become more drastic, particularly in foreign markets and especially in the United States. Portfolio fl ows from the eurozone and Japan are exerting heavy pressure on US long rates, which are already under pressure throughout the yield curve by reinvestments of maturing Treasury securities owned by the Fed. It is unlikely that this trend will quickly reverse.

 

PUBLICATION

 

 

In a visionary 2004 paper (“Conducting Monetary Policy at Very Low Short-Term Interest Rates”), Ben Bernanke and Vincent Reinhart indicated what central banks should do when their key interest rates reach their floor:

  1. providing assurance to investors that short rates will be kept lower in the future than they currently expect,
  2. changing the relative supplies of securities in the marketplace by altering the composition of the central bank’s balance sheet,
  3. increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term rate at zero (“quantitative easing”).

The recommendations of Bernanke and Reinhart's paper have been followed to the letter by the majority of central banks in developed countries in the
past decade.The convergence of key rates toward zero has led central banks to employ other methods besides conventional interest rate tools to stimulate the economy. The policy of quantitative easing (QE) has been applied by many central banks, including the Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ), the Bank of England (BoE) and Sweden's Riksbank.

The ECB’s and BoJ’s QE programmes have had a much greater impact than that of the Fed

Although the BoJ conducted a form of QE in the early 2000s, market players generally credit the Fed with launching the QE trend when it intervened heavily in the markets in the wake of the Great Recession. The Fed's QE programme proceeded in three stages (QE1, QE2 and QE3), each time with different formats, combining purchases of Treasury securities and mortgage-backed securities (MBSs). The Fed now holds over $2.4rn in Treasury securities and more than $1.7 trn in MBSs. The Fed's balance sheet is now about 25% of US GDP, compared to only 6% at the end of 2007. The impact of the Fed's QE programmes on long rates has been significant, both on US rates and on those of other developed countries.

Nonetheless, there is some evidence that the impact of the QE programmes conducted by the ECB and BoJ has been even more consequential than that of the Fed on the global bond markets.

One way of showing this is by examining the variation in net issues of sovereign bonds before and after central bank purchases, given that one of the aims of QE is to reduce long-term interest rates. Our calculations reveal that net issues of US Treasury securities never turned negative during the Fed's QE programmes, as powerful as they were. But the experiences of Japan and the eurozone have been radically different. In both regions, net issues of sovereign bonds became sharply negative after the implementation of QQE by the BoJ in 2013 and QE by the ECB in 2015. In the 12 months leading up to July 2016, net issues of sovereign bonds in the eurozone after Eurosystem purchases amounted to –€600 bn.

While it is clear that the Fed's QE had a significant impact on US long rates as well as the long rates of developed countries in general, it is increasingly evident that the programmes by the ECB and BoJ had even stronger impacts on their respective markets and, as we will see, on other bond markets too. Introducing the variable of “net issues of sovereign bonds after central bank purchases” into conventional macro rate models (long-term inflation anticipations, expected real short rates) leads to a substantial improvement in the predictive power of econometric regression analysis. A counterfactual analysis reveals that in Germany, the “premium” associated with QE amounted to approximately 60 basis points.

The ECB’s and the BoJ’s QEs weigh on US rates 

The QE programmes conducted by the ECB and BoJ have had a powerful impact on their respective bond markets, a trend amplified by the introduction of negative interest rates, with the entire yield curve being dragged down, in some places into negative territory. Low or negative bond yields have led residents to look for yield elsewhere while driving nonresidents to liquidate their positions in Japan and in the Eurozone. As a result, the euro and yen have fallen. One of the most remarkable consequences of the low bond yields caused by the policies of the ECB and BoJ is that investors’ search for yield has become more drastic, particularly in foreign markets. Each basis point matters. A significant share of the liquidity freed up by the ECB’s QE (€240 bn per quarter beginning in Q3 2016) is being used to buy up foreign bonds. In Q1 2016 alone, eurozone investors bought a net €152 bn in foreign bonds, including an unheard of €79 bn in US bonds. Overall, eurozone investors purchased a net €185 bn in US bonds over the four quarters ending Q1 2016. Meanwhile, Japanese investors bought a net $174 bn in US bonds over the 12 months ending June 2016. For the US bond market, this represents a considerable technical factor.

Portfolio flows from the eurozone and Japan are exerting heavy pressure on US long rates, which are already under pressure throughout the yield curve by reinvestments of maturing Treasury securities owned by the Fed (approximately $230 bn for 2016 and $200 bn for 2017). Purchases by European and Japanese investors, as well as investors from other Asian countries outside of China, are more than offsetting the sale of Treasury securities by the Chinese authorities.

The low interest rates are raising lots of questions for the Fed. The FOMC’s June minutes, for example, contained this sentence: “Actions by investors to shift their portfolios away from very low-yielding foreign sovereign debt were cited as adding to the downward pressure on US yields.”

The ECB and BoJ will find it difficult to put the brakes on QE 

Portfolio outflows in the eurozone and Japan are now very significant, offsetting significant current accounts surpluses (hovering around 3% and 4% of GDP, respectively) and going even further. This is keeping the euro and yen artificially low, since current accounts surpluses should theoretically help drive up these currencies. This also raises questions about how the asset purchase programmes of the ECB and BoJ will one day be ended. Let us assume, putting aside realistic expectations, that the ECB or the BoJ ends QE. If this were to occur, long rates would rise sharply, and in the case of the ECB, sovereign spreads would widen. With the rise in yields—not to mention portfolio inflows—it would be safe to assume that outflows would stop. In turn, the currency would sharply appreciate, which would ruin all the efforts made by the ECB and BoJ in an attempt to control deflationary pressure. Therefore, it will be very difficult for the ECB and BoJ to end their QE programmes, as currency depreciation is one of the main consequences of these policies.

 

The consensus view has consistently overestimated the future level of long rates in recent years

The charts opposite represent the difference between the 10-year rate forecast according to the consensus view of economists (Bloomberg) and the spot rate observed on the market, shown for the United States and Germany.

It is clear that the consensus view has consistently overestimated the future level of long rates. In other words, the consensus view always wrongly believes that long rates will rise. This is of course related to the belief that monetary policy would be ‘normalized’ rather rapidly (this proved to be repeatedly wrong). This is not the only bias in the consensus view. Our analyses also show that the consensus has consistently overestimated levels of growth and inflation in recent years. Among other systemic biases, in recent years economists have almost always anticipated that the US dollar would appreciate against the euro and yen.

A counterfactual analysis reveals that in Germany, the “premium” associated with QE amounted to approximately 60 basis points

 

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Cross Asset of September 2016 in English

Cross Asset de September 2016 en Français

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DRUT Bastien , Strategy and Economic Research at Amundi
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How the ECB’s and BoJ’s QEs are remodelling the fixed-income markets
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