What’s Next After QE?

Terry Flanagan

Macroeconomic themes, especially monetary policy, are at the forefront of investor issues as they try to assess the impact of accommodative policies that began with the financial crisis, as well as the seemingly inevitable unwind.

Front and center is quantitative easing, or QE, and its variants (QE1, QE2, QE3). Opinions on QE vary widely among economists, with some calling it a savior and others calling it disastrous. Most viewpoints expressed at Markets Media’s May 6 Fixed Income Trading and Investing Summit fell somewhere in between.

“QE was helpful in supporting the economy in this recovery. Fiscal tightening would have derailed growth,” said Yelena Shulyatyeva, U.S. economist, BNP Paribas. “Wealth effects significantly boosted real consumption in 2013, enough to offset fiscal drag.”

Consumption growth has remained remarkably stable relative to GDP growth in the current expansion despite the fact that households are more exposed to shocks today and have less of a buffer to smooth through income fluctuations. “QE pushed yields on safe assets to such low levels that rental yields were attractive for investors, so it cleared out excess supply in the housing market,” said Shulyatyeva.

Markus Schomer, chief economist at Pinebridge Investments, was less enthusiastic about QE. “QE2 and QE3 must be considered failures given the lack of inflation and economic growth over the past 3 years,” he said. “In fact, one of the main lessons of the QE period is that central banks cannot easily create inflation anymore. The helicopter is broken.”

Low short-term rates and the dampening of volatility has led investors to reach for yield to seek out better returns, noted Wes Sparks, head of U.S. fixed income at Schroders.

“The beginning of QE was beneficial and partially because of that, the U.S. economy has led the global economy out of the ‘08 crisis,” he said. “But now, the Fed trajectory is to not only to end QE but to also provide forward guidance, which they may start to back away from later this year. The Fed may be willing to allow a little more uncertainty about exactly when they will begin tightening – since monetary policy is now really data dependent.”

Injecting a little bit of volatility at this point in the credit cycle is a good thing – credit spreads have compressed and investor sentiment is bullish, said Sparks. “Too much certainty about continued accommodative policy could sow the seeds of bubbles,” he said.

The path of the Fed’s exit policies is extremely important now and how well the FOMC times the beginning of the fed funds rate hike cycle will determine if inflation ultimately becomes a problem and whether financial assets enter bubble territory before policy is normalized.

“The Fed is likely to embark on its first rate hike in 2015 – which will prove to be just one of a series of hikes – and perhaps sooner than current consensus expectations for the first rate hike in the 2nd half of next year,” Sparks said.

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