What really spooked the markets last fortnight was the apparent rethink by the high-powered US Federal Open Market Committee (FOMC) on the costs and benefits of the third round of quantitative easing (QE3). The minutes released on February 20 of the FOMCs monetary policy meeting held on January 29-30 showed that many committee members were in favour of ending, or at least tapering, the bond-buyback programme earlier than the markets expected. The US central banks massive bond-purchase scheme, through which it purchases $85 billion of bonds from the open market (and releases an equivalent amount), is currently open-ended, and was earlier expected to end only if there was a significant improvement in the labour market.
Some potential costs of the programme are somewhat obvious. The strategy of increasing base money by a humongous $85 billion a month (it works out to $1 trillion year) could at some point set off an inflationary spiral that could be difficult to control, also leading to a sharp build-up in inflation expectations. This is yet to happen. The market for inflation-indexed bonds has shown some increase in inflation expectations from 2010 but that has been far from a surge.
The other risk that hasnt really been discussed much is the threat to financial stability. Low interest rates and abundant liquidity usually lead to a rise in the issue of dodgy financial securities, and this time is no exception. Junk bond issuance has been rising sharply as has been the supply of payment-in-kind bonds, typically issued by distressed companies who wish to defer coupon payments and pay interest in additional bonds (hence in kind) rather than cash.
On the other side of the balance, the benefits of QE seem to have reduced considerably. The first two rounds of QE (late 2008 and second half of 2010) came at a time when deflation was the big risk and real interest rates threatened to go through the roof. Massive monetary easing helped stabilise real interest rates by both suppressing nominal interests and pushing up inflation expectations. However, over the last few months, real bond yields have actually moved slightly higher.
Then, there is the issue of potential capital losses. Currently, the US Fed earns substantial interest income from its bond holdings and is sitting on unrealised capital gains of about $250 billion. But capital gains could quickly turn into losses if the interest rate cycle reverses, especially since the composition of the central banks bond portfolio has shifted towards higher duration (more interest rate sensitive bonds). The more the Fed buys bonds, the larger is the expected amount of capital losses. The Feds paid-up capital is $50 billion and there could come a point where growing capital losses could lead to technical bankruptcy. The ramifications of a technically bankrupt central bank are yet to be known.
What does all this mean for the future of QE and the markets? The stance the Fed takes depends on Chairman Ben Bernanke (and other heavyweights like Janet Yellens) views on the subject. In his testimony last week to the US Congress, Bernanke recognised the costs of continuing with QE but suggested that the benefits still outweighed the costs.
Thus, an abrupt end to QE is unlikely but some reduction in the size of the programme is possible. Emerging markets will have to adjust to a situation in which the flow of liquidity into their asset markets whenever global investors get into a risk-on mode reduces going forward .This is particularly critical for India given the size of its current account deficit and the growing reliance on short-term liquidity-driven flows to fund this. When the markets begin to price in expectations of a cut or halt in the liquidity programme, the rupee could see depreciation pressures build up.
On a slightly different note, bad news is at least temporarily good news for the euro. The impasse over the Italian elections has managed to shed a good four big figures from the euro-dollar and has, in the process, reduced the overvaluation in the European common currency. The flip side is the fact that Italys failure to either continue with a government led by a hard-nosed technocrat or vote into power a coalition that would be on the side of continued internal reforms is a reminder of two things. First, Europes problems are far from over and second, the internal constituency for fiscal consolidation is at best weak.
The recent riots in Spain was primarily about corruption charges against the ruling party and prime minister Rajoy but there was a strong undercurrent of resentment against the severe austerity measures that Rajoy demanded.
The promise that European Central Bank President Mario Draghi made of doing whatever it takes to ensure the euros survival might have prevented an implosion in the region. It has, however, not made the road ahead for Europes peripheral economies any less rocky. The prospect of deterioration in Italys fiscal situation and worse-than-anticipated fiscal prints from Spain could rock the continents boat yet again and lead to another wave of anxiety. With Germanys election around the corner and continuing gridlock over the US fiscal deficit, the search for a safe haven is likely to continue.
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
