The biggest buyers in bond markets are now poised to become sellers, as central banks who purchased trillions of dollars of debt since the 2008 financial crisis start trimming their vast portfolios.
Leading central banks such as the US Federal Reserve and Bank of England are widely expected to kick off the process of “quantitative tightening” in the coming months, complicating the outlook for bond investors who are already grappling with runaway inflation and the spectre of aggressive interest rate rises this year.
The looming tightening of monetary policy marks a stark contrast to 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 large-scale asset purchase schemes that were used to arrest the global financial crisis a decade earlier.
“Central bank balance sheets will shrink in aggregate in size for the first time in history,” said Ralf Preusser, global head of rates research at Bank of America. “Some central banks may also experiment with [actively selling bonds], where we also have no experience.”
The BoE fired the starting gun on QT earlier this month, saying it would begin the process of gradually reducing the £895bn stock of debt it has bought over the past 13 years by ceasing reinvestments of government bonds it holds as they mature, as well as offloading £20bn of corporate debt. When interest rates rise from 0.5 per cent at present to 1 per cent — which markets expect as soon as May — the UK central bank will also consider actively selling gilts.
The Federal Reserve will probably begin the QT process later this year, investors say. It may offer more details of plans to wind down its $9tn balance sheet at its meeting next month, at which it is widely expected to raise interest rates for the first time since the start of the pandemic.
Now that employment and growth are surging, a reduction of the Fed’s balance sheet would allow it to withdraw some of the stimulus it injected at the start of 2020 to shore up the US economy.
Such a prospect comes as markets are now pricing in more than six interest rate rises in the US by the end of this year, with traders betting that the Fed will move decisively to stem surging inflation.
Another big source of demand for bonds is set to dry up, with the European Central Bank expected to phase out its own debt purchases later this year — although ECB QT is thought to be a long way off.
While expectations of rapid rate rises from the Fed and the BoE has stirred up markets in recent months, bonds appear to have largely taken the notion of QT in their stride. Longer-dated debt, which is generally perceived to have benefited most from quantitative easing programmes, has sold off much less sharply than short-dated bonds, which closely track interest rate expectations.
Some market participants view that as a sign that bond markets are remarkably complacent about the prospect of central banks taking a step back.
“Long-term bonds are effectively living in cloud cuckoo land,” said Craig Inches, head of rates at Royal London Asset Management. “Has the market priced QT in? No. People seem totally focused on rate hikes and aren’t thinking about balance sheets.”
The Fed at its January meeting said a significant reduction in its balance sheet would “likely be appropriate”. In a set of “principles” laid out at that same meeting, the Fed said that it would not begin reducing the size of its balance sheet until it had raised interest rates, but has otherwise not said anything about the timing of such a move.
The Fed has also said that it could shrink its balance sheet at a faster pace than when it last carried out QT following the 2008-09 financial crisis. Then, the Fed waited until 2017 to begin — roughly two years after its first interest rate rise.
To some investors, the relaxed attitude of bond markets to the onset of QT makes sense.
“If you look at the power of QE, it wasn’t so much that the central bank was buying bonds from the market but the powerful signal it sent that rates would stay low for a long time,” said Salman Ahmed, global head of macro at Fidelity International. “That’s the same for QT — it has to be thought of in terms of what it tells us about rates policy.”
Since the Fed has not indicated that balance sheet reduction is an alternative to rate rises — repeatedly insisting that short-term interest rates remain its primary tool for taming 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 go up faster,” he said. “It won’t be seen as a substitute for rate policy unless central banks tell us it is.”
Across the Atlantic, the UK may provide important clues on how markets respond to rate rises coupled with QT. So far, the former appears to have had a much larger impact, with longer-term debt faring much better than short-dated bonds in this year’s sell-off.
“I’m sure the Fed is going to be watching the UK. It’s probably quite a useful control experiment,” said Steven Major, HSBC’s global head of fixed income research. “If you look at [low long-term yields in the UK], the suggestion is there are plenty of willing buyers if the central bank just gets out of the way.”