The quantitative unwind proved short lived, pushing investors to take on more risk in search of yield.
Despite several years of sustained economic expansion and rising employment, the attempted unwinding of the extraordinary monetary policies of the post financial crisis era – quantitative tightening – proved short-lived.
Led by the Fed in early 2019, global central banks pivoted from tightening to easing in response to weakening global growth, persistently low inflation and trade policy uncertainty.
The Fed brought an early end to the shrinking of its balance sheet that is once again expanding as it injects liquidity into short-term funding markets, while the European Central Bank (ECB) resumed large-scale and open-ended purchases of euro sovereign and corporate bonds.
With most of the world’s central banks cutting interest rates, the global economy is benefitting from the most extensive monetary easing programme since 2010.
The Fed has set a high bar to unwind the 2019 ‘mid-cycle’ rate cuts and will only do so if inflation rises persistently above its 2% target.
Conversely, further rate cuts would only be prompted by a meaningful slowdown in jobs growth and a pick-up in unemployment.
The ECB has embarked on a strategic review of its monetary policy and stated it will ‘continuously monitor the side effects’ of its policies – an acknowledgement by new ECB President Christine Lagarde of the deteriorating cost-benefit calculus of negative policy rates and QE.
Like the Fed, the bar for a shift in policy from the ECB is high.
With major central banks set to keep policy rates unchanged through 2020, a pick-up in growth should lead to some modest bear steepening of yield curves.
But were growth to accelerate by more than forecast, a more meaningful re-pricing of inflation risk would follow.
QE anaesthetic for declining growth
Source: OECD; Macrobond; latest quarterly data for Q2 2019
The positive impact on economic growth and inflation of quantitative easing (QE) is diminishing – we are approaching the point of monetary exhaustion.
QE and ultra-low interest rates have become an anaesthetic for declining global growth and excessive debt.
But extraordinary monetary policies largely reflect the trend decline in productivity growth and real (inflation-adjusted) interest rates that pre-dates the global financial crisis, as well as the failure of governments to implement reforms that boost productivity and aggregate demand.
Even modestly positive real interest rates prove unsustainable in a world of persistently low nominal, as well as real, growth and high debt.
Yet the distortions from never-ending central bank liquidity and ultra-low interest rates are becoming systemic.
Resources are captured by rising numbers of ‘zombie’ companies surviving on easy financing, reinforcing the underlying problem of low growth.
Negative policy rates and quantitative easing have become persistent and pervasive features of the landscape facing investors across much of the world.
Traditional financial institutions – banks, insurance companies and pension funds – struggle to effectively allocate investment capital against the backdrop of negative yielding debt and nominal policy rates.
With lower-for-longer rates and bond yields firmly entrenched, investors are forced to take more risk to meet their return targets.
Investors have moved further out on the yield curve and take ever more duration in their portfolios, rendering their bond holdings more vulnerable to even small increases in interest rates.
Global fixed income market by yield bucket
Source: BofAML Global Fixed Income Index; October 2019
The search for yield is driving an increasing share of capital into alternative assets, such as private debt and infrastructure, as well as into credit and to a lesser extent emerging markets debt.
Investors are also adopting a ‘barbell’ between passive approaches to gain low-cost access to market ‘beta’ and total return strategies.
The latter actively manage duration and credit risks unconstrained by benchmarks and thus have the potential to better exploit relative value and idiosyncratic opportunities to generate additional return and diversification.
Investors are being forced to take more risk in the search for yield. Interest rate, credit, liquidity and manager (or alpha) risk must all be understood and responsibly managed.