What is quantitative easing and how does it affect the markets?

What is quantitative easing?

Quantitative easing (sometimes abbreviated to ‘QE’) involves the purchase of government securities by central banks in an attempt to stimulate economic growth.

Central banks are mandated to keep inflation within certain parameters to maintain a healthy economy. Normally, they do this by controlling interest rates, which is the amount of interest that banks pay to borrow money from one another. Interest rate changes are passed on to banks’ customers, so a reduction in central bank interest rates usually means consumers can borrow more cheaply, which increases spending and GDP. Lower interest can also mean that people earn less on their savings, incentivising them to spend their money instead.

However, if interest rates are already very low, central banks must look to other means to increase the monetary base. Quantitative easing entails the creation of new bank reserves that are used to purchase government bonds​ (for example, from pension funds). This increases bond prices, which reduces bond yields and lowers interest rates in the real economy.

Quantitative easing is often described as ‘printing money’. Money printing has, in the past, led to severe economic problems such as hyperinflation.

Central banks have recently used quantitative easing to mitigate the impact of the Covid-19 pandemic. For example, the Bank of England (BOE) – the UK’s central bank – bought £895bn of UK government bonds during 2020, in an attempt to maintain spending and investment levels while lockdown measures curtailed most economic activity.

Keynesian economic theory suggests these kinds of active economic measures can mitigate or prevent recessions by increasing aggregate demand.

How does quantitative easing affect the markets?

Different asset classes, including fixed income, equities and cash equivalents, are affected differently by quantitative easing. We explore a few of the financial markets below.

Fixed income

Fixed income assets (bonds) are the most directly affected by quantitative easing, since large-scale purchasing of bonds by the central bank pushes its prices up. This, however, reduces the yield on bonds as a percentage of its price. Learn about the advantages and disadvantages of high-yield bonds​.

Equities

Equities (stocks), therefore, tend to benefit from quantitative easing. Lower bond yields (and higher bond prices) reduce their attractiveness as an investment, which encourages capital allocation to equities instead. Additionally, companies may theoretically benefit from increased consumer spending as a result of lower interest rates, making them more likely to pay dividends to shareholders.

Cash equivalents

In a similar way to bonds, cash equivalents (like US government treasury bills or certificates of deposit) are negatively impacted by quantitative easing. The returns that cash equivalents generate for investors depend on interest rates, which are reduced by quantitative easing.

Commodities

Global commodity markets​ are traditionally priced in US dollars, and any large-scale QE program from the US federal reserve that devalues the dollar (due to the increased supply of newly printed dollars) can have a positive impact on dollar-priced commodities.

How does quantitative easing affect inflation?

Quantitative easing’s primary goal is to encourage spending in the economy. Therefore, an increase in consumer demand and supply of money implies an increase in inflation.

Central banks have a mandate to keep inflation within certain acceptable limits, so will sometimes use quantitative easing to increase inflation if it falls below target levels, or to counter deflation (as the Bank of Japan attempted unsuccessfully from 2001).

As a result, quantitative easing can sometimes lead to increased inflation expectations, which increases bond yields. Investors and traders tend to demand higher yields to compensate for inflation risk, which dampens expectations for more monetary measures.

Advantages of quantitative easing

Quantitative easing isn’t just a tool used by central banks to increase money supply and encourage lending, but has various advantages including:

• Reduced borrowing costs thanks to lower interest rates.

• Increased money supply thanks to reduced borrowing costs.

• Higher consumer spending thanks to greater availability of money.

• Higher corporate profits, meaning: reduced unemployment rates (which in turn leads to increased consumer spending); and higher dividends, meaning increased asset prices in equity markets.

• In theory, quantitative easing leads to a devaluation of currency. This benefits manufacturers, as it makes their exports cheaper for overseas customers.

• All of this, in theory, increases GDP, an important economic indicator​.

Disadvantages of quantitative easing

There are critics of quantitative easing that say there can be negative consequences, including:

• New money being mostly spent, directly or indirectly, on equities. Stocks are disproportionately owned by the wealthiest members of society, who may invest or save rather than spend money.

• It, therefore, takes a lot of quantitative easing to create a small increase in the real economy. Quantitative easing can also be inefficient and increase inequality.

• Risks moral hazard in context of government borrowing.

• Risks extreme currency devaluation, making imports prohibitively expensive.

• Hyperinflation, when money effectively loses its purchasing power, is another potential negative side effect. In this respect, quantitative easing is similar to ‘helicopter money’ – a term that refers to the printing of large sums of money and giving it directly to the public for free.

• In the worst case, quantitative easing can lead to inflation or hyperinflation without increasing economic activity. This is called stagflation.

How can traders take advantage of quantitative easing?

In general, any comments from central bankers providing forward guidance on rates and/or quantitative easing represent a trading opportunity. Typically, quantitative easing reduces the returns from safe investments (such as tax-free bonds​​​) and pushes investors towards stocks, which then increases their prices.

However, because investors will respond rapidly and en masse to any announcement, markets don’t necessarily wait for explicit statements from central banks before this price rise happens.

Often, deteriorating economic indicators and starkly negative economic news will raise expectations of upcoming quantitative easing, and investors may consider how to trade stocks in anticipation of this in an attempt to get ahead of the curve. Given that this often means greater share purchases and a consequent increase in prices, these indicators can potentially turn bad news into good news as markets rise in anticipation of quantitative easing.

Central banks will not usually allow the stock market to decline beyond a certain point and will step in with policies to reverse any serious declines. This is generally known as the ‘Fed put,’ with some specific instances named after the respective Federal Reserve (Fed) chairs that instigated them (for example the ‘Greenspan put’ in 1987 and the ‘Powell put’ of 2019).

Because of the Fed put, investors may choose to ‘buy the dip​’ when asset prices fall in the knowledge/hope that central banks will step in to reverse any severe falls in the market. This can lead to overpricing of assets, causing asset bubbles​.

In theory, any quantitative easing policy will be reversed and eventually ended once it has achieved its stated aim of stabilising the economy. This process is known as tapering, whereby central banks slow their purchasing of assets. However, no central bank that has implemented a QE policy has ever successfully fulfilled its promise to end it.

Central Bank quantitative easing history

The theory that underlies quantitative easing is relatively straightforward. In practice, however, different central banks have implemented quantitative easing in different ways, for different reasons, and often with very different (and hard-to-predict) results. It is important to understand how central banks’ monetary policy programs have worked in practice before formulating a trading strategy.

Federal Reserve (FOMC)

Supply of bank credit and exchange of treasury securities in the US is controlled by the Federal Open Market Committee (FOMC)​, a branch of the Federal Reserve. Formed in 1933, the FOMC soon began permanent open market operations (POMO), such as the continual purchase and sale of US Treasury securities in order to influence interest rates.

While Alan Greenspan’s tenure as chair (which began in 1987) was characterised by ongoing indirect quantitative easing through repurchase agreements, it was after he stepped down in 2006 that the Fed began direct quantitative easing, specifically in response to the global financial crisis. In November 2008, the Fed purchased $600bn-worth of mortgage-backed securities (MBS) in response to the sub-prime mortgage crisis. This was expanded in March 2009 with an additional $750bn of MBS and $300bn in Treasury security purchases.

In a second round of quantitative easing, the Fed purchased $600bn longer-dated treasuries at $75bn per month between November 2010 and June 2011. A third round was announced in September 2012, involving $40bn of MBS purchases per month in an attempt to ‘substantially’ improve the US labour market. This was tapered out between December 2013 and October 2014.

During the coronavirus pandemic, between March and July 2020, the Fed purchased $3tn in financial assets and engaged in a bond-buying programme from August 2020. Monthly bond purchases of $120bn were pledged to support the economy’s recovery from the pandemic as vaccinations were rolled out.

Bank of England (BOE)

During the financial crisis, between March and October 2009, the Bank of England (BoE) purchased £175bn of assets (mostly UK government debt – gilts – as well as some high-quality corporate debt). In November 2009, the Monetary Policy Committee (MPC) voted to increase this to £200bn. By July 2012, the total had risen to £375bn.

Brexit was the next event that saw the BoE announce purchases of £60bn-worth of UK government bonds. The central bank also purchased £10bn of corporate bonds in August 2016 to allay concerns over the economic impact of Brexit.

Its most recent round of quantitative easing was during the coronavirus pandemic. An emergency meeting in March 2020 led to the announcement of £200bn-worth of government bond purchases, with £100bn and £150bn announced in June and November 2020, respectively. This brought total quantitative easing in the UK to £895bn.

European Central Bank (ECB)

During the European debt crisis, the European Central Bank (ECB) began buying covered bonds in May 2009 and purchased €250bn of sovereign bonds from member states in 2010 and 2011. Until 2015, the ECB was reluctant to refer to these activities as ‘quantitative easing’. In January 2015, the bank changed tack, and ECB President Mario Draghi announced €60bn in monthly purchases of euro-area bonds. This amount was increased to €80bn in March 2016 and continued to December 2018 (by which time it had been tapered down to €15bn monthly). Purchases were resumed at €20bn monthly rates from September 2019.

In March 2020, the ECB announced a Pandemic Emergency Purchase Programme (PEPP) of €750bn, which was increased by €600bn on 4 June and by €500bn on 10 December, to a total of €1.85tn. The programme’s aim was to reduce the cost of borrowing and increase lending in the eurozone.

Bank of Japan (BoJ)

The Bank of Japan (BoJ) was the first central bank to implement a quantitative easing policy, which it did in the early 2000s to counter deflation, despite describing quantitative easing as ineffective for years. In March 2001, the bank purchased large amounts of government debt in order to increase liquidity in the banking system. In four years, this policy added ¥30tn to commercial bank current account balances.

In an attempt to reduce the US dollar value of the yen and thereby encourage exports, the BoJ did ¥5tn of asset purchases in 2010. The policy was unsuccessful. In August 2011, the BoJ increased the commercial bank current account balance from ¥40tn to ¥50tn. In October, the BoJ’s asset purchase programme increased to ¥55tn.

In April 2013, the central bank again announced an increase to its asset purchase programme, to ¥60-70tn annually. The aim was to reverse deflation with a target inflation rate of 2%. The policy was expected to double the money supply and has been dubbed ‘Abenomics’ after Shinzō Abe, the Japanese Prime Minister who oversaw the policies. The BoJ did it again in October 2014, when its asset purchase programme increased to ¥80tn bonds annually.

However, from 2016, the BoJ switched to an approach called yield curve control (YCC) with the objective of keeping 10-year Japanese government bond yields at close to 0%. This enabled it to scale down its bond-buying programme.

People’s Bank of China (PBOC)

Speculation abounded that China’s central bank had implemented quantitative easing during the 2020 Covid-19 pandemic. Holdings of sovereign bonds by ‘other’ investors (which can include central banks) rose by CN¥196.5bn to CN¥1.78tn in July 2020, according to Bloomberg. The figure had risen just CN¥24bn the previous month, suggesting a big increase in the central bank’s purchase of government debt.

However, in late August Sun Guofeng, head of monetary policy at the People’s Bank of China (PBoC), insisted that the bank would maintain a ‘normal’ monetary policy and that there was no need for the bank to adopt quantitative easing or zero/negative interest rates.

Liu Guoqiang, vice governor of the PBoC, told the same briefing that there was no need to lower Chinese banks’ capital adequacy ratios. However, in June 2021, the bank raised the foreign-currency requirements of domestic banks from 5% to 7% in response to the yuan’s strengthening against the dollar and the consequent inflation in the price of Chinese exports.

How does the tapering of quantitative easing affect the markets?

Quantitative easing increases bond and stock prices​ by increasing demand for the former and adding cash to the economic system to be spent on the latter. Tapering off from quantitative easing decreases demand for both, meaning their prices fall.

This can affect both markets differently. For example, when the Fed began discussing tapering its quantitative easing programme in 2013, bonds experienced a rapid sell-off while stocks became more volatile. After this initial volatility when the prospect was announced, markets stabilised through the rest of the year – before tapering had even come into effect.

The fall in bond prices increases bond yields and can act as an incentive to saving. In 2017, the Fed accentuated this effect by commencing quantitative tightening, which is when a central bank sells government bonds back into the market to create negative asset flows on its monthly balance sheet.