End to QE could unleash massive volatility
Central banks saved the world with unconventional monetary policies such as quantitative easing, which at the very least stopped the banking system from collapsing, but according to the IMF it's a policy that might be approaching its sell-by date. But unwinding it will unleash intense volatility across forex and asset markets.
The IMF warned in its Global Financial Stability Report and World Economic Outlook on Thursday May 16 that unconventional monetary policies if carried on against a backdrop of relative economic stability could create volatility in the financial system and asset bubbles.
One of the unusual market features stemming from nearly four years of aggressive monetary policy from leading central banks such as the U.S. Federal Reserve are the synchronized rallies across all the main asset classes. This is largely because the pricing mechanisms of markets have been distorted by torrents of central bank money as they cease to reflect fundamental factors.
Therefore a withdrawal of extreme easy money is also likely to spur synchronised bear markets across those same asset classes with gold, silver and the risk currencies likely to suffer considerably. This time commodities including gold, copper and oil have not mirrored the recent equities rally. And during May even the 10-year U.S. Treasury yield started rising, so investors are beginning to anticipate some sort of change.
Ending QE would mean more downside for gold
For much of this year the Fed has made public that it is mulling over winding down its quantitative easing program and the Bank of England has, for the time being, decided not to start a new one. The IMF's warnings over asset bubbles add to this mood music and are helping pave the way for a change in market sentiment.
The U.S. dollar is likely to be the big winner as the Fed would lead the way in the withdrawal from unconventional monetary policies. The U.S. economy is growing at least, whilst the U.K.'s is hobbling along, the Eurozone remains mired in recession and Japan is still playing catch-up.
Some risk currencies are already heading lower
Equity markets remain remarkably complacent judging by sentiment measures, such as the VIX index. But also currencies such as GBP, which has managed to stabilize recently with the Bank of England ceasing to talk it down and because it is putting new QE programmes on hold.
The EUR is likely to fall further and commodity currencies such as AUD, NZD and CAD are already in full retreat vs. U.S. dollar. The newly debased JPY, may turn out to be a little less vulnerable as Japanese investors typically repatriate funds during periods of high volatility and that means buying their own currency. It remains to be seen if the Bank of Japan has decisively changed the mindset of the Japanese investor with its attack on JPY.
However, the little growth there is in developed countries has been achieved on the back of these vast liquidity injections. The question is could the U.S. economy maintain some sort of growth without it, particularly with sequestration – tax rises and government spending cuts – gathering momentum.
The rout in equities and possibly bond markets that would follow a tightening of monetary policy would also concern policy makers who attach so much importance to the 'wealth effect' created by rising asset prices. It could also cause stress on the balance sheets of commercial banks due to their mandated large holdings of government bonds and other funding strategies, which depend on cheap money. That would mean more expensive credit for the real economy.
Any return to recession in the U.S. would swiftly lead to an end of talk of cancelling QE. There may even be an unwinding of QE by the end of the year, but given the sluggish nature of the U.S. recovery it is likely that QE will once again be deployed. But in the meantime, an attempt to withdraw it will unleash intense volatility across currencies and asset markets as they realign themselves for a new monetary reality.
However, one thing is for sure is that the world will eventually have to learn to live without QE as continuing to use it fosters potentially damaging financial bubbles, which could lead to another global crisis.