In 2009, Sir Mervyn King said that the process of unwinding quantitative easing (QE) – central banks injecting printed money into the economy by buying bonds – was “incredibly straightforward”. In fact, says Sam Fleming in The Times, “it is proving to be a nightmare”.
Markets “have been in tumult” ever since late last month, when US Federal Reserve chairman Ben Bernanke merely hinted that the Fed might slow down the pace of its asset buying in the not-too-distant future. If just a hint of tighter money causes this much fuss in today’s liquidity-addicted markets, what will happen if he really does start turning off the taps?
To those who remember 1994, it all looks ominously familiar, says Jim O’Neill of Goldman Sachs on Bloomberg.com. Back then, Fed chairman Alan Greenspan had made it “reasonably clear” that the Fed was about to start raising interest rates. Yet when the Fed actually moved, it still seemed to come as a shock to investors everywhere (other bond markets tend to be priced off US Treasuries).
Given the huge sell-off in Australian bonds, for instance, “you’d have thought an inflation panic was breaking out”. But the exodus was due to all the people who had rushed into Australian and other developed-market bonds to take advantage of the yield spread over Treasuries. In the US, ten-year Treasury yields gained around 2.5% throughout 1994. American stocks finished the year marginally down, but had a very rocky ride. This time round, as O’Neill points out, “the search for yield has gone wider and deeper” as years of money printing have reduced Western government bond yields to record lows, and sent investors into riskier assets, ranging from junk bonds to emerging-market bonds and currencies. Markets are, in short, far more distorted than they were then. You can see why former Fed vice-chairman Alan Blinder is concerned that we could see worse turbulence than in 1994.
If there is a 1994-style bond rout, it could “detonate a series of new bombs” in the American banking sector, says Fleming. US regulators are concerned that banks, like investors, “have been doing crazy things to chase yield”, as one banker puts it. So a sharp jump in yields as US rates move up would be extremely bad news for banks and, by extension, for America and for global recovery. It will be “fiendishly difficult”, concludes Gillian Tett in the Financial Times, “to exit from QE without triggering shocks”.
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