Fixed income project quantitative easing

Fixed Income Analysis Project

Quantitative Easing

Brought to you by:Jacob SreekumaranNg WenyingKritika RajeevWang Si Jie Jessie

Zhao Xin ZhuWu ShanCao Ya JieMeng Ming Jiao

Quantitative Easing What is QE and How it works?

An unconventional monetary policy used by Central Banks to stimulate economy when standard monetary policy becomes ineffective

Central Bank

Inflation Target

Characteristics- Central bank must have control over its currency to implement QE- Open Market Operation- Mainly Long term bonds (has to affect cost of borrowing)- Lower interest rates further out on the yield curve

Quantitative Easing What is QE and How it works?

Central Bank

Inflation Target

$

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1. Where did the Money Come from?

2. What are the Effects? 3. What are the Risks?

Quantitative Easing 1. Money Creation Mechanism

Central BankCredit their own account with money out of nothing: Simply

created by electronically adding a number to an account

Banks & Financial Institutions

Purchase financial assets (e.g. Government and Corporate

bonds) in OMO.

Banks now have excess reserves for them to create new money by the process of deposit multiplication

from increased lending in the fractional reserve banking system

Money Supply

-- Deposit Multiplication --

Quantitative Easing 2. Effects

Economic Effects- Lowers interest rates- Reduction in systematic risks- Improvement in market confidence- Depreciates country’s exchange rates Stimulates exports- Higher stock prices boost consumer wealth Spur spending- Boost employment

Limitations- Reverse inflation more than target Hyperinflation- Bank may still be reluctant to lend in a climate of increasing defaults- Capital flight to other markets e.g. Emerging market, instead of lending to local

businesses - Cost-push inflation instead of demand-pull inflation (due to rise in cost of factor of

productions)

Quantitative Easing 3. Risks

Wealth inequalityIncrease in prices of stocks has disproportionately helped the wealthy who own thevast majority of the financial assets (Bank of England, 2013)

UnpredictabilityLack of control over when the excess money supply will be loaned out (EconomistJohn Tayor, 2012)

Decrease in real value of savings and pension fundsLow yield rates induced by QE adversely affect returns on pension funds fund willstretch over a shorter period of time (World Pensions Council, 2012)

ProtectionismAs net exporting countries have their currencies pegged to the Developed nations,QE causes appreciation of other currencies thereby impacting their export demands(BRIC, 2012)

Quantitative Easing 3. Risks

Over-leverageExtremely low rates encourage borrowing Increase leverage in corporates Risky if finance already fragile

Rising interest rates in futureLarge scale buying of bonds in market limits the government’s ability to liquidatetheir positions Interests rates to rise in future limits economic growth

Negligence by governmentLoss of market discipline and negligence by government in tackling issue ofincreased debt usage if QE can help finance government debts easily

Accumulation of risky assetsIssue of who will subsequently buy the risky assets How to resolve? (Exit Plan)

Quantitative Easing Applications of QE – Japan, US & Europe

Japan

When: Long-standing stagnant growth (0.5%) despite zero interest rate since the huge stock and property price bubble burst in 1990s

When: Japan’s growth had been stagnant and was coming under increased pressure by the cost of rebuilding after the massive earthquake, tsunami and a nuclear meltdown in 2011. - Yen was appreciating due to uncertainty in global

market (flight to less risky assets; Yen)- Unemployment high & population aging

When: Japan’s new minister Shinzo Abe promised to end decade long low inflation & ‘cash hoarding’ phenomenon and crafted a series of policies “Abenomics”

QE 1(Mar’2001 – 2006)

QE 2(Oct’2011 – 2012)

QE 3(Apr’2013 – now)


- Increased commercial bank current account balance ceiling from ¥5 trillion to ¥35 trillion for 4 years

- BOJ bought bills and government bonds- Lower interest rates- Vanquish deflation

- Increase commercial bank current account balance ceiling to ¥50 trillion- Expand asset purchase to ¥55 trillion- BOJ bought government bonds and other securities- Curb Yen’s appreciation - Stimulate exports and inflation

- BOJ to buy ¥7 tr assets each month- Push up prices- Policies to encourage firms to raise

wages - Consumer spending increase- Manages market expectation

QE 1

QE 2

QE 3


United States

When: Subprime crisis triggered a financial crisis causing default of MBS and CDO. Banking system affected Domino effect on employment and economyInterest rates was close to zero and conventional solutions didn’t work.

When: The recovery was sluggish, banks were reluctant to lend, unemployment was over 9% Growth & inflation is very low Risk of deflation Interest rate remains close to zero but didn’t help stimulate economy.

When: To support a stronger economic recovery and to help ensure that inflation would be stable. Job growth needed a boost.

QE 1(Dec’2008 – Jun’2010)

QE 2(Nov’2010 – Jun’2011)

QE 3(Sep’2012 – Oct’2014)


QE 1- $600B MBS and other debts mainly

backed by Fannie Mae, Freddie Mac, Ginnie Mae and FED Home loan banks

QE 2 - $600B in long term Treasuries- $250B- $300B proceeds from MBS

reinvested- Operation Twist:

- $400B proceed from treasury bills will be reinvested to buy long term bond

- FED will continue to buy long term bond when MBS mature

QE 3- Keep interest rates low till mid 2015- Buy $85B of asset each month- Setting Targets:

i. Unemployment falls below 6.5%ii. Inflation hits 2.5%

Setting Targets Regain market confidence Spurs consumption


United Monetary Policy

+Small economies took

advantage of low borrowing cost

European Debt Crisis

EU’s Monetary Policies- Lower Interest rates- European Financial

Stability Facility (EFSF)- Make loaning easier- Purchase Covered

bonds

Eurozone is entering stage of recovery.

Long term bond yield falling since 2012

Threats of Deflation

QE?

Double digit unemploymentin member nations

+


- Lending Program• ECB loans out to banks based on sovereign

guarantees • Relaxed computation of debt-GDP ratio fulfill

Masstricht criteria qualify for ECB’s assistance• Refinancing rates cut from 0.15% to 0.05%• Deposit rates cut to negative -0.2%• Lengthen maximum maturity of refinancing

- Credit Easing• Private sector credit• Purchase of ABS• 20th Oct Purchase of Covered bonds: a type of

debt secured by a pool of loans such as mortgages

No full pledge QE yet...

Quantitative Easing Effectiveness of QE

QE1- Barely effective

QE2- Temporary depreciation of Yen- Global trend of risk aversion cause demand

for less risky assets like Yen to increase- Volume of QE was negligible; more signal-

effect than money supply effect

QE3- Yen weakened 25% against US- Maintained current acc. surplus- TOPIX rose 22% (Feb’13)- Unemployment fell from 4% to 3.7%- Q1’13 Consumer spending up 3.5%- Aug’14 core inflation: 1.1%


QE1- DJIA increased from 7000 to 11200, by 60%- CRB Commodity index increased from 340 to 510, by 50%- Employment rate had no significant change QE1 resulted in a significant and lasting decline in long-term

interest rates; resulted in a total decline of 96 basis points for the 10-year Treasury and 104 basis points for the 30-year MBS.

QE 2- Add 0.13% to the annual rate of economic growth in 2010,

which was at 2.8% when the program was implemented- DJIA increased from 10000 to 12800, by 28%- CRB Commodity index increased from 500 to 690, by 38% QE2 was not effective in reducing both the 10-year Treasury

yield and the 30-year MBS yield.

QE 3- Unemployment rate decreased from 8.3% to 8.1%- DJIA increased from 12100 to 13600, by 12.4%- CRB Commodity index increased from 500 to 600, by 20%. QE3 only effectively reduced the 30-year MBS yield for 46 basis

point.


Bond yields in countries like Spain and Italy are near record lows.

Distribution of money supply across nations is an issue

Asset bubble Worry that money flow intoStocks instead of companies and households

ECB stress test Shows ability to generate credit growth is limited

Opposition from GermanyPreferred to wait to gauge the effects of four-year ECB loans to banks, before taking new stimulus measures. Believes that Eurozone inflation has bottomed out and that after one or two months it should begin to gradually drift higher

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✗German BundsBuying government bonds almost certainly means buying German Bunds than other debts, pushing Berlin’s yield down faster


Critical Factors for An Effective QE

1. Favorable Global conditions2. Size of QE3. Availability of Bonds in market4. Adequate control over domestic currency5. Focused effort (e.g. Abenomics)6. Management of market expectation 7. Credibility of government8. Consensus in market

Quantitative Easing Aftermath of QE

Update on what are the countries doing

Japan US Europe

BOJ will be publishing assessment of economy on 31st Oct’14- Likely to keep QE till inflation target reached

QE3 tapered and ended in Oct’14 Keeping interest rates low for

now How to get rid of large amt of

bonds?

Recent ECB stress test shows limited ability to generate credit growth. After the test, its time ECB will look into more expansionary policies. (Inflation was 0.3% Sept)

Disposal of $3 Trillion of Debts• Can’t sell $3 Trillion of securities at a time Interest rates rise steeply Disrupt

economic recovery• Possible solutions:

• Allow securities to expire at maturity• Cooperate with Treasury: Reduce issuance of long-term bond so FED can sell long-

term bonds in market and buy short-term debts reduce impact on yield curve

1

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Exit Plans

Gain effective control over interest rates• Control rise in FED fund interest rates with I/r on reserve and overnight reverse REPO rates

Thank you

Brought to you by:Jacob SreekumaranNg WenyingKritika RajeevWang Si Jie Jessie

Zhao Xin ZhuWu ShanCao Ya JieMeng Ming Jiao

Economy & Finance

Fixed income project quantitative easing