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Whatwill

happen

to

markets

when

QE

ends?

GavynDavies29th May 2013

1

FucumRech

Last weeks market reaction to Fed Chairman Bernankes suggestion that the FOMC might begin to taper

back QE within a few meetings represented a trial run for what might happen when central bankers

really do remove the punch bowl at some point in the future. The largest reaction came in the most

leveraged markets (notably the Nikkei, which fell by 6.5 per cent), but there were simultaneous across-the-board declines in global bonds and equities.

When the Fed ended QE1 and QE2, there were declines in the S&P 500 index of 15 per cent and 23 per

cent respectively. These events, however, proved to be only minor fluctuations in the great bull market,

which quickly resumed when the central banks announced new asset purchases.

Many analysts1 believe that QE has caused a major bubble to appear in asset prices, the full extent of

which will be unveiled only when the central banks start to shrink their balance sheets. Others reply that

the rise in both bond and equity prices has been justified by economic fundamentals.

This is probably the most important debate in the financial markets today, with enormous ramifications

for both policy makers and investors. Bubbles are notoriously difficult to identify in real time, and it is

wise not to be too dogmatic about this.

The immediate response of the major asset markets will depend on the exact economic circumstances at

the time, the existing state of market expectations and extent of leverage in each of the major asset

classes. However, we would like to comment on three major questions in the bubble debate in US

markets, since the answers to these fundamental questions are likely to frame the global market response

over a lengthy time period after QE ends.

F i r s t , i s t h er e a b u b b l e i n g o v e r n m en t b o n d m a r k e t s?

Clearly, government bond yields are substantially below their historic averages, but that does not

necessarily mean that they are in a bubble, which would be true only if yields have dropped much

1For example, Gillian Tett argues in the FT (http://on.ft.com/18rJWKG)that the reach for yield has artificially inflated all asset prices, with

the consequence that there could be a bout of violent instability if a shock, such as the end of QE, hits the system. Paul Krugman

(http://nyti.ms/11JOBsq)and Antonio Fatas (http://bit.ly/13Ts6ze)reply that extremely low real yields are a natural consequence of the

excess of global savings over capital investment, and of similarly low short term interest rates, so neither bonds nor equities are in a bubble.

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further than would be implied by economic fundamentals, especially by the decline in expected short

term interest rates.

A large part of the decline in yields can indeed be explained by the prolonged period of near-zero short

rates which is now built into the bond market. But not all of it can be. Ben Bernanke recently pointed out

that long bond yields have actually fallen by more than can be explained by the drop in expected short

rates (see the first chart).

Almost 2 percentage points of the decline in US bond yields stems from the so-called term premium in

long term interest rates, which is the unexplained residual in the long yield after taking account of the

expected path for short rates. A negative term premium is extremely unusual, implying that the market is

willing to lend to the government on long term debt for a lower rate of return than they expect to receive

from rolling over shorter term loans for the same length of time. Since the latter strategy is more liquid, a

negative term premium would not generally be expected to arise, and it might be a mark of a bubble.

The Fed Chairman does not think so, arguing that the negative term premium is an understandable

consequence of fundamental factors, including the safe haven demand for bonds, the attraction of

bonds as a hedge against riskier assets, and the demand for bonds from foreign central banks.

Several of these factors can be seen as being ultimately linked to the excess of global savings over

investment, which has been associated with the recession and the central bank policy response. But, even

if you do not choose to view this as a bubble, and to some extent this is a matter of semantics, the drop in

yields has clearly brought forward bond returns from the future into the present, implying that forward-

looking bond returns will be abnormally low.

Sec on d , w ha t i s t h e c a se fo r a r g u i n g t h a t t h er e i s a b u b b l e i n eq u i t y m a r k e t s?

It is clear that the reach for yield has started to have a profound effect on sectoral behaviour within global

equities, as argued in this earlier topical commentary2. But, at least until recently, there has been

relatively little sign that equities had become overvalued, because the equity risk premium had widened

substantially (see the second chart).

Essentially, as the bond yield has dropped into unprecedented territory, the earnings yield on equities

has remained roughly constant, implying that equity prices have been underpinned by the growth of

corporate earnings. An alternative way of looking at this is to argue that the equity risk premium, proxied

in the graph by the gap between the earnings yield and the bond yield, has increased almost in lock-step

with the decline in bond yields.

As investors have sought the safe haven of bonds, they have simultaneously demanded a higher risk

premium for holding equities, and that risk premium might offer some protection to share prices if the

bond yield starts to rise. There has been some decline in the risk premium recently, but much of the

cushion still seems to be intact. The main worry about equities, therefore, is that corporate earnings

cannot maintain their high share of nominal GDP indefinitely, but that is another matter entirely.

T h i r d , w h a t d o es al l t h i s i m p l y f o r f u t u r e r et u r n s ?

Central bankers have typically been unwilling to talk much about this question, but it seems clear that

their actions on interest rates and QE have brought forward returns from the future, even if they have not

2Gavyn Davies(2013), Equity markets join the global reach for yield, 5 May2013 -http://on.ft.com/ZzJuEk

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caused a bubble in bonds or equities. The outgoing Bank of England Governor Sir Mervyn King, showing

increasing candour as retirement approaches, admitted as much in his final BoE press conference

recently:

The reason for concern in the future is that we know that at some point real interest

rates have to get back to a healthier and more normal level You would expect to see

some consequences for asset prices, possibly falls in asset prices. It will be important

that people have had time to get to a point where their degree of indebtedness is not

such that they find themselves in deep financial trouble when asset prices fall.

Sir Mervyn is saying here that it has been a deliberate strategy of the central banks to drive yields down,

and therefore bring asset returns forward from the future, in order to help with the process of private

sector deleveraging.

Whether or not they have created bubbles in the strict sense of the term, the unavoidable consequence

of central bank action since 2009 is that they have reduced the returns to be expected in the future.

However, that process has not yet advanced anywhere near as far in equities as it has in government

bonds and credit. That fact is likely to go a long way towards framing the eventual long term response tothe end of QE. In summary, bonds seem much more vulnerable to a very lengthy period of sub-par

returns than equities appear to be.

29th May 2013

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D i s c l a im er

Source: This article is based partly on material which appeared in an article by Gavyn Davies published

in the Financial Times on May 26th 2013.

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