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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