When crowding out becomes crowding in

Quantitative easing

With interest rates near zero and the economic recovery as lacklustre as it began, many people accuse central banks in the developed world of 'pushing on a string'. However, don't underestimate the impact that this buying has on asset prices.

Traditional monetary policy is relatively easy to understand. When interest rates are pushed up, bond yields and the discount rate applied to future cashflows increases. When interest rates are pushed down, the reverse happens.

 

So far, so straightforward.

 

But in today's world of zero/negative interest rates and quantitative easing, things become a little harder to understand. Many accuse central banks of 'pushing on a string' in their attempts to stimulate economic activity and inflation. Understanding exactly how negative interest rates, long-term loans to the banking system and asset purchase programmes are likely to impact the economy is undoubtedly complicated.

 

However, the impact on asset prices is a simpler story of supply and demand. Financial assets are in limited supply, and central banks have (potentially) unlimited demand. Consider the chart below. Over the next twelve months, G4 governments will issue around $1trillion of debt. Normally, economists would argue that such large debt issuance will 'crowd out' other assets unless the overall pool of global savings increases to accommodate the extra supply.

Chart showing the aggregate central bank bond purchases exceeding the government bond issuance over the next twelve months across the G4 countries

However, over the next twelve months, the bond purchases from the Bank of Japan and the European Central Bank are set to outpace issuance by over $700bn. And that includes the money borrowed by the US and UK governments.

 

This is the 'portfolio rebalancing channel' of quantitative easing. Investors are forced out of government bonds into other assets. If, in aggregate, investors are unwilling sellers then the price is forced up (yields are forced down) until enough sellers emerge. Quantitative easing may have a muted impact on the economy (discuss!), but its ability to lift asset prices should not be doubted.

 

It is a simple matter of arithmetic. If the demand for fixed income assets consistently outstrips the supply of those assets, prices will get pushed up and yields will get pushed down.

 

Many argue that the government bond market is a bubble that is about to go 'pop'. However, for this to unfold we need to see huge net selling from the private sector (>$700bn per annum) to offset the flow from central banks. Many private sector holders of government bonds have to buy for regulatory reasons (e.g. insurance companies, pension funds holding bonds to hedge liabilities), so it is really not clear to me where such an enormous liquidation will come from.

 
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