Rise of the evil twin - Quantitative Tightening
Wednesday, November 18, 2015
It is surely not an overstatement to say that the financial
markets suffered carnage over the last few weeks as testified by the sharp
spike in VIX, a popular measure of the implied volatility of S&P500 index
options and of course a “sea of red” across most investors’ portfolios.
What is really causing this state of uncertainty and panic in the
market? The commodities slump and discussion involving Greece are somewhat
passé topics though the devaluation of Chinese yuan and depressed oil prices
still seem to hoard headlines. If we transported ourselves in a time machine to
post-2008 financial crisis, we would find ourselves entering an unprecedented
era of quantitative easing (QE) where central banks embarked unconventional
monetary policies by purchasing financial assets and increasing money supply in
the financial ecosystem. Fast-forward seven years later to the economy of
today, we might see the rise of QE’s evil twin, Quantitative Tightening (QT).
Drawing lessons from the 1997 Asian Financial Crisis (AFC),
foreign central banks such as China and Japan have accumulated vast quantities
of foreign reserves over the last decade, particularly in the form of US
Treasury debt. This presumably helped emerging economies to mitigate currency
shocks as witnessed in 1997 AFC where large stockpiles of foreign reserves
allowed banks to intervene any free-falling action on their national currencies
with buy-back options on open market. The accumulation of foreign reserves also
prevented undesired appreciation against the Greenback as QE was introduced
alongside zero interest rate policies.
Since late 2014, oil prices nosedived to sub-$40 per barrel or in
perspective, a six-year low in August 2015. The gradual decline in oil prices
has led to a reduced investor’s appetite for US Treasury debt from oil
producing nations such as Saudi Arabia. Typically, these countries recycle
their excess profits into USD to prevent their national currencies from
appreciating on the back of strong oil prices.
Over the last three months, China was believed to have disposed
some US$143 billion worth of US Treasury debt as the sell-off in the Chinese
stock market initiated a flight of financial assets across all classes. While
some foreign brokerages predict the phase of liquidating US Treasury debt to
persist, the real flip side of it is the upward pressure on yield rates. This
surely does not bode well given that the Fed is also expected to announce its
first rate hike either in September or sometime in 2015.
The catalyst for greater dismay is the Fed’s intention in allowing
the existing US Treasury debt to mature without a roll-over. While this is
executed in good faith of shrinking the exploding balance sheet, in excess of
US$4.5 trillion, it would be extremely challenging given the current headwind
led by foreign central banks selling US Treasury debt extensively.
While it has been established that QE involves the buying of US
Treasury debt thereby pushing up bond prices and driving down yields, the
reverse mechanism of liquidating US Treasury debt by foreign central banks
should be viewed as the evil twin named QT.
As we sit on the side-lines
speculating the timing of the rate hike, the global economy seems to face
another rising problem with QT. Could we potentially see QE4 instead of a rate
hike? You never know.
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