The biggest buyers in bond markets are now poised to turn sellers, as central banks that have bought trillions of dollars of debt since the 2008 financial crisis begin to shrink their vast portfolios.
Major central banks such as the US Federal Reserve and the Bank of England are widely expected to initiate the process of “quantitative tightening” in the coming months, complicating the outlook for bond investors who are already struggling with galloping inflation and the specter of aggressive interests. rate increases this year.
The impending monetary policy tightening contrasts sharply with the coronavirus response measures implemented in early 2020, when central banks around the world cut borrowing costs to historic lows and launched the type of programs purchase of large-scale assets that were used to stop the global crisis. financial crisis a decade earlier.
“Central bank balance sheets are going to shrink globally for the first time in history,” said Ralf Preusser, global head of rates research at Bank of America. “Some central banks may also experiment [actively selling bonds]where we also have no experience.
The BoE kicked off QT earlier this month, saying it would begin the process of gradually reducing the £895bn stockpile of debt it has bought over the past 13 years in ceasing to reinvest the government bonds it holds as they mature, as well as offloading £20bn of corporate debt. When interest rates drop from the current 0.5% to 1% – which markets are expecting as early as May – the UK central bank will also consider actively selling gilts.
The Federal Reserve will likely begin the QT process later this year, investors say. It could offer more details on plans to shrink its $9 billion balance sheet at its meeting next month, where it is widely expected to raise interest rates for the first time since the start of the pandemic.
Now that jobs and growth are rising, a reduction in the Fed’s balance sheet would allow it to withdraw some of the stimulus it injected in early 2020 to support the US economy.
Such a prospect comes as markets are now pricing in more than six U.S. interest rate hikes by the end of this year, with traders betting the Fed will act decisively to stem soaring inflation. .
Another big source of demand for bonds is set to dry up, with the European Central Bank set to phase out its own debt purchases later this year – although the ECB’s QT is thought to be a long way off.
While expectations of rapid rate hikes from the Fed and BoE have rattled markets in recent months, bonds appear to have largely embraced the notion of QT in their stride. Longer-term debt, which is generally seen to have benefited the most from quantitative easing programs, sold much less sharply than short-term bonds, which track interest rate expectations closely. .
Some market participants see this as a sign that bond markets are remarkably complacent about the prospect of central bank pullbacks.
“Long-term bonds do indeed live in cloud country,” said Craig Inches, head of rates at Royal London Asset Management. “Has the market priced in QT’s price?” No. People seem totally focused on rate hikes and not thinking about balance sheets.
The Fed at its January meeting said a significant reduction in its balance sheet would be “probably appropriate”. In a set of “principles” laid out at that same meeting, the Fed said it would not begin to reduce the size of its balance sheet until it raised interest rates, but did not moreover, nothing is said about the timing of such a decision.
The Fed also said it could shrink its balance sheet at a faster pace than during the last QT operation after the 2008-09 financial crisis. Then the Fed waited until 2017 to start – about two years after its first interest rate hike.
For some investors, the relaxed attitude of the bond markets towards the appearance of the QT makes sense.
“If you look at the power of QE, it was not so much the fact that the central bank was buying bonds in the market, but the powerful signal it was sending that rates would stay low for a long time,” said Salman Ahmed, Global Head of Macro at Fidelity International. “It’s the same for QT – you have to think about it in terms of what it tells us about pricing policy.”
Given that the Fed has not signaled balance sheet reduction as an alternative to rate hikes – repeatedly insisting that short-term interest rates remain its primary tool for controlling inflation – markets assume that the two policies are complementary, according to Ahmed. “An early start to QT would be a signal that rates are going to rise faster,” he said. “It will not be seen as a substitute for interest rate policy unless central banks tell us it is.”
Across the Atlantic, the UK can provide important clues as to how markets react to QT-coupled rate hikes. So far, the former appears to have had a much bigger impact, with long-term debt faring much better than short-term bonds in this year’s sell-off.
“I’m sure the Fed will be watching the UK. It’s probably a pretty useful controlling experience,” said Steven Major, global head of fixed income research at HSBC. “If you look [low long-term yields in the UK]the suggestion is that there are plenty of willing buyers if the central bank steps aside.