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The $9 Trillion Question: What Happens When Central Banks Stop Buying Bonds?

Posted by hkarner - 11. Mai 2017

Date: 10-05-2017
Source: The Wall Street Journal

Central banks have been the world’s biggest buyers of government bonds and may soon turn into sellers

Recent data showed that the European Central Bank holds total assets of $4.5 trillion, more than any other central bank ever. Above, the ECB headquarters in Frankfurt.

Central banks have been the world’s biggest buyers of government bonds and may soon turn into sellers—a tidal shift for global markets. Yet investors can’t agree on what that shift will mean.

Part of the problem is that there is little agreement about how the massive stimulus policies, known as quantitative easing or QE, affected bonds in the first place. That makes it especially hard to assess what happens when the tide changes.Many expect bond yields could rise and shares fall, some see little effect at all, while others suggest it is riskier investments, such as corporate bonds or Italian government debt, that will bear the brunt. But recently, yields on European high-yield corporate bonds hit their lowest since before the financial crisis, in one potential sign that the threat of tapering has yet to affect markets.

When the unwinding begins money managers may not be positioned for it, and markets could move swiftly. In the summer of 2013, investors suddenly got spooked about the Federal Reserve withdrawing stimulus, leading to a swift bond sell off that sent yields on the 10-year Treasury up by more than 1 percentage point.

By buying bonds after the 2008 financial crisis, central banks across the developed world sought to push yields lower and drive money into riskier assets, reducing borrowing costs for businesses.

“If it’s unclear what benefits we’ve had in the buying, it’s unclear what will happen in the selling,” said Tim Courtney, chief investment officer at Exencial Wealth Advisors.

Recent data showed that the European Central Bank holds total assets of $4.5 trillion, more than any other central bank ever. The Fed and the Bank of Japan each have $4.4 trillion, although the BOJ isn’t expected to wind down QE soon.

With the world economy finally recovering, investors believe that holdings at the Fed and ECB have peaked. U.S. officials are discussing how to wind down their portfolio, which they have kept constant since 2014. The ECB’s purchases of government and corporate debt are now more likely to be tapered later in the year, analysts say, after pro-business candidate Emmanuel Macron’s victory in the French presidential election Sunday.

A raft of research from analysts and central banks estimates that these policies lowered 10-year sovereign-bond yields by around 1 percentage point in the U.S. and U.K. and by half a percentage point in the eurozone.

But it is unclear why.

Economists traditionally thought that it is only what central banks do with interest rates that really matters. Yields went low because interest rates went lower—even negative in places. If investors believe that officials will peg short-term rates at zero for the next 10 years, they will buy a 10-year sovereign bond yielding more than zero. It shouldn’t be important how many bonds are around.

Some investors say that, if QE works, it is mostly as a message from central bankers to markets that they are committed to low rates. If that is correct, then officials can protect markets from a steep selloff even if they sell back bonds, as long as they loudly commit to keeping interest rates low.

For the ECB, the challenge is to “disentangle the rate expectations from the tapering,” said Bastien Drut, a strategist at French asset manager Amundi.

Yet, research suggests that not all of QE’s impact has been rhetorical.

Much of it may be down to a “stock” or portfolio effect, which happens when sovereign bonds become scarce. Many investors always want to buy government bonds, given they are safe and liquid. So whenever central banks suck this debt out of the market, money managers have to fight over what is left, pushing down yields.

Any central-bank selling would then increase the stock, pushing yields higher.

In the U.S., if that happens and borrowing costs rise, then there would be less pressure for the Fed to raise short-term rates.

“We might have a positive surprise down the line with the Fed not going as hard as we now think,” said Neil Williams, chief economist at Hermes Investment Management.

Mr. Williams calculates that selling a third of the Fed’s bond portfolio would have roughly the same effect as raising rates to 3% from their current 1% level.

That in turn could dent U.S. stocks, which would look more expensive if safer assets yielded more, said Mark Heppenstall, chief investment officer at Penn Mutual Asset Management. In April, the S&P 500’s cyclically adjusted price-earnings ratio was at its highest since 2002.

But investors often pay even closer attention to the “flow effect” of QE, said Fabio Bassi, chief European rates strategist at J.P. Morgan Chase & Co., which is the impact that daily purchases by central banks have on markets.

Bonds are stockpiled by banks, which profit by dealing in them. If these banks know they can always sell a large chunk of their stock to the central bank, they are more willing to offer investors a better price for those bonds. Riskier, less liquid assets particularly benefit.

This flow effect is much stronger in the eurozone than the U.S., according to recent research by the Bank for International Settlements and the ECB.

In the 30 days after QE announcements, the impact was larger for less liquid assets like corporate bonds or the debt of weaker economies like Italy and Spain, data shows. Safer government bonds were usually less affected, with the exception of the first round of buying by the Fed back in 2008.

So, if the ECB stops its monthly €60 billion ($66 billion) of purchases, it is the weaker government debt and corporate bonds that could be hardest hit.

“Those countries that have weaker macro dynamics, such as larger debt piles, will be affected more strongly,” said Arnab Das, a senior analyst at Invesco. “If it’s not done carefully, at the bare minimum the transition could be extremely disruptive.”

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