Central banks face a huge challenge in successfully weaning the world off ultra-accommodative monetary policy and reducing the sizes of their balance sheets. Their actions helped calm the waters during the storm that was the Great Financial Crisis 2008/2009 [GFC]. Initially they cut interest rates dramatically, to below zero eventually in some cases. They also collectively spent the equivalent of more than $10 trillion on bonds through QE.
A key question now is, can they turn off the taps of cheap-money and safely unwind those holdings without precipitating a disorderly sell-off in fixed income markets? The actions taken so far have been modest and the markets’ reaction has, for the most part, been orderly.
A slow normalisation of interest rates has already begun. The US Federal Reserve (Fed) has increased rates five times in two years and the Bank of England (BoE) raised rates for the first time in ten years last November. The problem is, having left rates so low for such a long period; they may now face a world where ultra-low interest rates are the “new normal”. Economies may have become more sensitive to increases in interest rates. Central banks may not now be able to raise rates far enough to give themselves scope to make impactful cuts should they need to in the future.
As well as raising interest rates, the Fed has now started reducing the amount of assets it holds. The European Central Bank (ECB) also recently announced that it will be scaling back its bond purchases. Reducing their holdings carries some significant risks for central banks. In moving from being net buyers of bonds, to becoming net sellers, they risk tipping the supply/demand balance so that yields rise and spreads widen too quickly, potentially unleashing a disorderly and disruptive sell-off.
Fixed income markets were relatively benign through much of 2017, with little volatility. The lack of volatility not only masks, but contributes to, a significant build-up of risk. Many market commentators have been highlighting the potential for a disorderly reversal in markets, so even a small event or policy mistake could change sentiment quickly, with significant consequences for bonds.