The US Federal Reserve's exit from its "giant step into the unknown" of Quantitative Easing (QE) will most likely result in a "Goldilocks" economy that's neither too hot to cause inflation nor too cold to cause a recession, says Harbour Asset Management's head of fixed income Christian Hawkesby.
Hawkesby, who prior to joining Wellington-based Harbour, spent nine years working at the Bank of England where his roles included Head of Market Intelligence, Chief Manager of the Sterling Markets Division, and Private Secretary to the Deputy Governor, makes this prediction in a paper on the impact of quantitative easing on the bond market.
After the global financial crisis and with no room left to cut interest rates, the Fed introduced QE which amounts to it expanding its balance sheet in an effort to help lower long-term interest rates and expand the availability of credit.
It was initially done through emergency liquidity schemes and direct loans to banks at the beginning of the credit crunch in 2008. The Fed then moved on to purchases of mortgage-backed securities and agencies debt, and some US Treasuries (so-called QE 1) which cost a total of US$1.7 trillion, in November 2008. It then embarked on more purchases of US Treasures (so-called QE 2 costing US$600 billion) in November last year and is scheduled to finish this in June this year.
Four possibilities when QE ends
Hawkesby points out the combined result of these loans and asset purchases has been to expand the Fed’s balance sheet threefold. He suggests there are four broad scenarios for when the Fed switches back to more normal policy settings.
i. Hawkish Fed: Typically, there is always a chance that the Fed misjudges the speed of economic recovery and increases interest rates too quickly. This seems very unlikely this time around, given the Fed’s determination to see a sustained recovery, and to wait for unemployment to fall markedly - an economic indicator that tends to lag other indicators of economic health (We think this is 0% probability).
ii. Goldilocks: With a gradual economic recovery, the Fed would be able to raise interest rates at a gradual pace back to normal, as they did in 2004. This scenario broadly covers a multitude of situations where the Fed “gets it broadly right”. This may even include the lack of economic recovery prompting QE3, before an eventual return to normal. At the moment, the market still trusts the resourcefulness of the Fed to navigate a steady course to recovery (60% probability).
iii. Inflation: But if the economy was to recovery rapidly, then the Fed would be forced to increase interest rates very quickly, as they did in 1994. Although less likely, there is a reasonable chance of this scenario playing out, and it is certainly what the market is beginning to consider as a key risk (30% probability).
iv. Stagflation: An even scarier scenario is that the economy does not recover, but that cost pressures push up inflation expectations and force the Fed to raise interest rates to put a lid on inflation. This would hurt both the economy and asset markets (10% probability).
"The point I'm trying to get across is you talk to a lot of people about what's going on in the bond market and they say 'interest rates are low, I remember 1994 and rates shot back really sharply and it's going to be a disaster because it's going to be a repeat of that episode'," Hawkesby told interest.co.nz.
"(But) what I'm trying to do in this paper is try to help people think through that it doesn't have to be that scenario. It really depends on a lot of factors that you've got to weigh up. Particularly the outcome for the economy and inflation and how long that's going to take its way to work through."
Although putting a 60% weighting on the Goldilocks scenario, Hawkesby notes Harbour Asset Management still puts a 30% weight on the inflation, 1994 scenario meaning it sees a "material" chance of that happening.
"Everything's still dependent on how quickly the US economy recovers and how quickly unemployment comes down and how quickly core inflation starts tracking back towards a more normal level," Hawkesby said. "Only time will tell."
He notes that QE was a giant step into the unknown for both policymakers and financial markets and has driven down global interest rates and the US dollar, as well as feeding a massive rebound in credit, equities, and commodities.
"The end and exit from Quantitative Easing will be a key influence on global markets over 2011 and 2012, well beyond the US bond market," said Hawkesby.
So what are the implications for the NZ bond market?
Here in New Zealand Hawkesby said there are grounds to be watchful, but saw some mitigating factors.
"First, NZ interest rates were not driven down as far by QE. The level of NZ interest rates is around two percentage points higher than in the US across most maturities. And while NZ short-term interest rates are low by historic standards, (and expected to rise as the economy recovers), NZ long-term interest rates are already reasonably close to normal levels."
Secondly at about 60%, holdings of New Zealand government bonds by non-residents are not especially high by historic standards.
"Much of the increase in NZ government bond issuance has been taken up by local banks strengthening their liquidity and funding positions, in response to stricter regulation. So as US interest rates rise, there is less danger of large-scale selling by non-residents rushing back to invest in the US bond market," Hawkesby said.
Thirdly, the outlook for NZ economic growth is dependent on the timing of recovery efforts in Christchurch after February's devastating earthquake and the household deleveraging cycle.
"So the threat of near-term demand-led inflation pressures is less obvious in NZ," said Hawkesby. "Finally, while the NZ fiscal deficit has deteriorated in recent years (and will be hit again by the costs associated with the Christchurch earthquake), by international standards it looks less ugly than many other countries."
"In particular, NZ began the global financial crisis with a relatively low level of government debt to GDP (see chart 14 in Hawkesby's presentation). Even if the NZ government is downgraded a notch by the credit rating agencies, its rating remains high in absolute terms."