The beginning of the end of monetary stimulus policies
RIDING the waves of loose monetary policies such as ultra low interest rates and relentless liquidity injections from major central banks, global stock markets have been on the steady course upward for the past several years.
Volatility has been unusually low, on a premise that central banks stand ready to step in to stimulate the economy if anything bad were to happen. That’s particularly true in the US, where the S&P500 has been rallying without any 5 per cent pullback in the past year.
Prior to this cycle, the index had been experiencing a 5 per cent dip once every six months on averฌage. But all that could be about to change. Since late June, the world’s most powerful central bankers have been singing hawkish tunes in droves. Mario Draghi, the president of European Central Bank (ECB), hinted at reducing the size of his Quantitative Easement (QE) programme, saying “the central bank can accompany the recovery by adjusting the parameters of its policy instrument”. Said his UK counterpart, Mark Carney: “Some removal of monetary stimulus is likely to become necฌessary”. While warning about lofty stock marฌket valuation fuelled by low interest rates and ample liquidity provided by the central bank, US Fed chair Janet Yellen said, “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios”.
In short, the world’s major central banks are wary of the risk of the economy running “too hot” and signalling the unwinding of the monetary stimulus they had put in place over the past decade.
In particular, the Fed is widely expected to announce a plan to wind down its massive bond portfolio in September, which in effect will result in a gradual removal of liquidity from financial markets. The ECB will likely follow by announcing its own plan to reduce the size of the QE programme effective next year.
The removal of monetary policy supports is unprecedented and could prove disruptive to global financial markets. Going forward, financial market volatility could increase, as investors would no longer be able to rely on central banks’ intervention to keep markets afloat.
Moreover, these accommodative monetary policies are designed primarily to suppress longterm interest rates, hence keep borrowing costs down and encourage financial risk taking. Riskier asset such as equities, speculative grade highyield bonds and emerging market bonds have been prime beneficiaries as they provide higher return alternatives to the depressed government bond yields.
Therefore, the most probable impact of reversing these policies would be the rise in longterm bond yields, which will in turn exert downward pressure on risky asset prices.
