Quantitative easing is when central banks purchase assets from the market to lower interest rates and increase credit availability to help stimulate the economy.
February’s correction in equity markets appeared to have limited contagion spreading to other markets, but the money markets are now pricing in an increased probability of the US Federal Reserve (Fed) hiking interest rates three times in 2018. A significant rise in interest rates could disrupt the economy in three ways:
Tightening financial conditions: Rising interest rates are tantamount to a tightening in financial conditions. This is symptomatic of liquidity withdrawal from markets. Given the importance of liquidity to asset markets in recent years and the role central banks have played in providing this, any liquidity uncertainty is likely to require investors to demand higher returns for the risk they’re taking.
This can result in falling asset prices. Hit to confidence and wealth: As interest rates adjust to the new economic outlook, valuations across asset markets may become more vulnerable. It is not uncommon for asset volatility to increase as we move into the later stages of the economic cycle, as the US currently finds itself. All else being equal, higher interest rates typically mean higher discount rates are used when valuing assets. This leads to asset values falling, and so negatively affecting wealth and impacting on consumer spending and business investment.
Impairment to credit channels: Rising interest rates result in higher debt servicing costs for businesses and consumers. While the earnings outlook may be positive, lower interest rate coverage ratios will leave many leveraged businesses vulnerable to higher financing costs.
After eight years of quantitative easing (QE), a more direct concern for investors is that the central bank safety net may be taken away. QE provided investors with cover in entering the riskiest of investments with little fear, while suppressed volatility helped to reinforce the view that central banks ‘have your back’.
We believe central banks will be less inclined to manage rate expectations lower in an environment where inflation risks are rising. When the economy was still recovering and unemployment and excess capacity were more elevated the Fed could reasonably maintain accommodative rate settings, even as growth was surging. This is because moderate productivity and underutilised capacity allows for economic growth without pushing up prices and inflation. However, in the late stages of an economic recovery, as we find ourselves now, the ability for central banks to hold back rate expectations in support of risk markets is significantly curtailed. This results from the fact that in the late cycle there is an acute trade-off between growth and inflation, with the potential for inflation to pick up rapidly.
Over the coming months it is likely that financial markets and central banks will hash out a new equilibrium, as equity markets and central banks adjust to the reality of higher (and potentially more volatile) economic growth and inflation. Equity markets will need to adjust to the likelihood of higher interest rates, while bond markets will need to incorporate the possibility of higher growth and inflation with less accommodation coming from central banks.
Whenever there is a sharp divergence between economic data and market expectations there is a good chance there will be a violent response in asset prices. In the past, central banks have managed to suppress this volatility via QE and by managing interest rate expectations lower. Going forward, there will be less scope to do this as we move into the late cycle where growth and inflation trade-off more acutely.
At the same time, an overly restrictive Fed, that tightens too quickly in anticipation of rising inflation, risks stalling the economic expansion and potentially sparking the next downturn. Confronted with these options the Fed has an incentive to let inflation run higher and for inflation expectations to become more deeply ingrained, before completely winding down the party.
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