Bond reversal

by daniel archibald


The implosion of the mortgage-backed security market and collapse of Lehman Brothers saw capital markets duck for cover and the freezing of the flow of money throughout the global economy. Creditors stopped lending money and investors looked to switch out of equities and other growth assets and into cash. Stock prices crashed and the world entered a great recession. 

To combat the 'credit crunch' governments and central banks around the world look to thaw the capital that had become locked up on balance sheets and cash accounts. And there main levers were monetary policy. 

The first part of the monetary strategy for most parts of the developed world was to slash cash rates to zero percent. Scared investors, who had decided to stash funds in bank accounts, would now be enticed back to growth assets. A risky return would likely be better than no return for many investors. 

Cash rates also influence long-term rates, and the slashing of rates to zero helped push down long-term rates. However, in order to help entice creditors to start lending again, long-term rates would have to come down much further. Money would need to be cheaper. 

The second part of the monetary strategy was quantitative easing (QE) with the US Federal Reserve Bank leading the global economy in purchasing Government bonds, bank debt and mortgage-backed securities. The basis for the bond purchase was simple supply and demand; the greater the demand the higher the price of bonds would go and higher bond prices equate to lower bond yields or interest rates. From 2008 to 2014 the Fed purchased a total of approximately $3.8 trillion worth of securities (QE1, QE2, and QE3). To fund these purchases, the Fed simply created new money, which, other than driving down long-term interest rates and mortgage costs, also flooded the economy with liquidity. 

Europe, the UK and the original QE economy, Japan, have also built up the balance sheets of their central banks since 2008, with the amount of money created in the process leading to a world full of money and ultra-low rates. In some countries (e.g. Switzerland, Germany), this flood of capital has even led to negative interest rates. 

But all good things must come to an end and then need for central banks to start selling bonds and debt securities is rising. The US Fed announced in April 2017 that it would look to begin the 'quantitative tightening' process later in the year. Much of this work could happen automatically through maturing debt, with the Fed electing to not rollover bonds and securities that are nearing the end of their terms. 

Overall, however, the scale of any bond sell-back is likely to be only a fraction of the purchase programs known as QE1,2 and 3, with the Fed balance sheet likely to be still be laden with US treasuries, bank debt and mortgage-backed securities. And even though European and Japanese central bankers are committed to winding down the expansion of their respective balance sheets, it may still be a while before they might consider turning of the monetary taps.



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