Adam Smith believed in the invisible hand, meaning an economy works best in a free market scenario with participants acting in their own interests. More than 200 years later, Central Bankers thought differently. In the aftermath of one of the worst financial crises in history, Central Banks have taken significant unconventional measures primarily by reducing base rates and buying fixed income securities in order to lower borrowing costs and hence stimulate demand. Today, after nearly eight years, global growth and inflation are finally picking up, reducing the need for ultra-accommodative monetary policies. Can Central Banks pull back from the market without creating a hiccup or is continued monetary stimulus the new norm?
Today, the Fed is the first Central Bank to unwind its unconventional monetary policy. So far the results have been mixed. When it announced in 2013 that it would start ‘tapering’ its bond purchases, investors panicked and fixed income markets lost -4%¹ over two months. However, since December 2015, when the Fed first raised the Fed Funds target rate, the market reaction has been fairly muted. One of the lessons learned from the Taper Tantrum is that Central Banks need to telegraph their actions well in advance. As such, markets are carefully watching the Fed’s plan on when and how they will stop reinvesting their huge portfolio of government bonds and agency-mortgage backed securities of USD 4.5 trillion².
As the European economy follows the footsteps of the U.S., the ECB is preparing market participants for less quantitative easing. Indeed, improvements in the unemployment rate and signals from surveys such as PMIs suggest that ultra-accommodative policy is no longer required. In March, the final Targeted Longer-term Refinancing Operation (TLTRO II) operation was conducted and this month, the ECB is reducing its monthly purchases of its Asset Purchase Program (APP) from EUR 80 billion to EUR 60 billion.
No one knows for certain when the next downturn will hit, but there are few immediate warning signs. However, it seems increasingly likely that Central Banks will still have some level of easing in place if another crisis happens in the near future, as it will take several years to normalise their balance sheet. This poses the question to what further actions Central Banks can take and how effective they will be.
How could fixed income investors position their portfolios when the visible hand retreats from the market? U.S. agency-mortgage backed securities and Treasuries look vulnerable because we expect the Fed to hike rates at a more rapid pace than priced by the market and to stop reinvesting their bond purchases later this year. Equally, Eurozone government bonds and investment grade corporates might feel the pain as the ECB, the largest buyer of these securities, is gradually reducing its purchases. Instead, bonds that provide a high level of carry without much duration risk look relatively more attractive. As such, high yield bonds, particularly USD-denominated, look best placed as credit spreads generally compress in times of rate hike cycles. Moreover, higher yielding corporate debt benefits from the improved growth environment which should support corporate earnings, decrease leverage and reduce the probability of defaults.
¹Source: Bloomberg Barclays US Aggregate Total Return Index. Data from 2 May 2013 to 24 June 2013.
²Source: Federal Reserve Quarterly Balance Sheet Development Report. March 2017.