QE and interest rates are slippery topics.
So we've come to the conclusion that people must know what the actual impact of QE (quantitative easing) and interest rate changes is.
At university, they'd teach you that low rates and quantitative easing are automatically inflationary...
But is that true?
Everyone's seen charts like this 👇
And this 👇
So everyone thinks they know how QE and interest rates work. It's usually some variation of this:
"They print money to pump up the stock market"
"Low rates cause stock market bubbles"
Which are more half truths than the full picture. Lots of context missing, and the correlation/causation line is blurry at times.
QE/QT basics were covered here 👇
But we need to expand.
What is the actual impact of QE and interest rates?
Well, there are two key variables...
- Impacts on asset prices (financial economy)
- Impacts on bank lending (real economy)
First, the one we degenerates all care about most. Making the stonk markets move up or down.
Impacts on Asset Prices
When central banks implement QE & low interest rate policies, they deliberately suppress yields on 'safe assets' like sovereign bonds & cash, making them less attractive to hold.
This suppression is supposed to encourage investment, lending and a wealth effect. The Bank of England says so 👇
- The lower interest rate on government and corporate bonds feeds through to lower interest rates on loans for households and businesses.
- That helps to boost spending in the economy and keep inflation at target.
- QE also affects the prices of other assets like shares and property.
For anyone with savings of any kind (including pensions), this is a problem.
Because excess eapital is yield-seeking.
Which sounds less greedy than 'people seek yield in return for their excess capital.'
Think of like this. Once your everyday expenses are covered, everything left in your account is excess.
Excess = Savings.
If you have 10k in savings, you'll probably leave it in your bank account.
You'll tolerate a low interest rate (yield), in return for ease of access.
It's your emergency fund so you're not so bothered about returns.
However, once you've got $50k, you start thinking about all that money sat there earning nothing when interest rates are low.
You start to shop around for investments. Banks will offer you all sorts of products depending on your risk tolerance. Maybe you ignore the banks and decide to YOLO into the latest sh*tcoin. Maybe buy an investment property or two.
Interest rates increasing and the housing market has been a hot topic with Macrodesiac Premium members recently.
If you have $100k, maybe you do all of the above.
Scale this up, and you start to understand how the investment world works:
excess capital is entrusted to money managers so that it can be invested to earn yield/returns.
The hunt for yield drives everything
Not just any old yield though (and we can think of yield also as interest earned on anything but bank deposits too)...
If yields were the only thing that mattered, Argentina wouldn't have a debt crisis every five minutes and we'd all be buying Turkish & Brazilian bonds instead of US treasuries.
Nope, this is all about risk-adjusted yields. Put another way, it's about value for money. Except it's called return for risk.
The general rules there go as follows...
High risk = Higher yield
Low risk = Lower yield
And the aim of the game is to find the sweet spot between risk and yield.
Expectations around central bank decisions on QE, QT & rates are one of the main factors that define that sweet spot. It's a constantly moving target.
There are some general rules of thumb however and we're going to paint with a really broad brush to illustrate here.
The main thing the QE/Low Rates combo does is push investors further along the risk spectrum.
(Which is why you see large retirement funds like Calpers getting creative just to keep up. More on that 👇
What does this mean in real-world terms?
Imagine you want to keep things simple and only invest in the US.
You could categorise your options like this 👇
Then add context.
For example, if the Fed's just lowered interest rates and started QE, what do you do?
Cash is trash & bond yields are in the toilet, so those two are out (or at absolutely minimum levels). Everything else is IN 👇
You move further along the risk spectrum as interest rates decrease.
Exact allocations will vary depending on risk appetites of course, but the bias towards higher risk is clear.
So, let's presume that works for a while. All is well, the portfolio's growing...
But as the cycle progresses, caution sets in 👇
Things start to look different. Interest rate hikes are coming, there might be word of central banks stopping quantitative easing and economic growth is slowing...
Blue chip and large cap firms should keep performing, but everything else is a lot less certain... 👇
So you probably trim a bit off the riskier bets (or stop out of them).
As the cycle continues to evolve, the yield curve flattens/inverts, and the overall mood shifts towards risk off.
Whatcha gonna do NOW?
And if the sh*t really hits the fan...
The dash for dollars. Everything gets sold for USD's. In a proper risk off liquidity crunch, everyone wants dollars to settle debts. Nothing else will do.
What About Quantitative Tightening?
Quantitative tightening is the opposite of quantitative easing, and occurs when interest rates are increasing.
If excess capital is yield-seeking, what provides the yield?
Capital is Asset-Seeking & Assets are Capital-Seeking.
Yield is the price that satisfies both sides of the negotiation.
Assets compete with each other to attract capital by offering yields that attract capital-holders.
In a tightening environment, there's more competition.
Central banks have switched sides. Not only have they stopped buying government bonds, they've also started selling them (active balance sheet runoff).
Government bonds will always attract demand: for all kinds of regulatory reasons plus safe low-yield investment vehicles, insurers & pension funds will want to hold them too.
Once that underlying demand is satisfied though, yields will need to increase to attract more capital.
Which starts to make bonds more attractive relative to other assets.
And we go full circle, back to those risk-adjusted yields.
If the safest assets are now offering a juicy return, the pressure's on those other (riskier) assets to attract capital by offering even better returns.
Howard Marks nailed it here 👇
That's the investment and wealth effect angles covered.
In Part 2, we'll look at the impacts of QE/interest rates on bank lending & the 'real' economy. 👇
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