Project Syndicate: The bond market’s QE Catch-22

United States

DUBLIN, Ireland (Project Syndicate)—Central banks’ unconventional policies undoubtedly rescued financial markets in 2020 when the COVID-19 pandemic was at its height. But those actions now leave central banks joined at the hip with credit markets, and market participants more reliant than ever on their support.

From a credit-market perspective, this represents a Catch-22 for both central banks and investors. How can central banks continue to support the economic recovery while developing an exit strategy that doesn’t undermine market stability? And how will investors, who prize stability but also seek higher yields, react if and when monetary policy makers step back from providing direct market support?

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Central banks are clearly not responsible for today’s investment decisions, but the longer their market support continues, the riskier the search for yield may become. Monetary policy makers and credit investors alike are facing an unenviable dilemma.

With low interest rates for most of the past decade, it was clear from the start of the COVID-19 crisis that central banks had little room for maneuver with conventional policy tools. They would have to lean even more heavily on unconventional measures, including initiating or extending corporate asset-purchase programs.

In the case of the Federal Reserve, the announcement of these measures during 2020 coincided with investment-grade corporate bonds’ peak spread.

Uncertain impact of QE

“Coincided” is the key word here. It is not clear whether these actions mean that conventional tools are now less effective in restoring market confidence in times of stress, or whether the pandemic’s idiosyncratic nature required a precision strike of support to the particularly vulnerable corporate sector.

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The widespread use of asset-purchase programs could simply have been the last in a long line of measures that finally brought market stress under control. Or it could represent a recalibration of how active and forceful central banks need to be in a crisis. At the very least, the new precedent in terms of market expectations that their extreme actions have set will be difficult to ignore in periods of stress in the future.

Central banks’ actions, alongside governments’ unprecedented fiscal support, restored financial stability in 2020. They also indirectly fueled record corporate bond issuance and a 60% drop in investment-grade corporate bond spreads from their March highs.

This restoration of stability was hard won, requiring extensive quantitative easing (QE) and new or extended interventions, particularly in corporate credit markets. Through a combination of rate setting, financing, and widespread QE, central banks now play a more pivotal role than in the past.

What’s the plan?

But what is their long-term plan? Central banks could maintain QE, as the Fed has suggested and the European Central Bank has done in the past, but protracted QE can be difficult to unwind and could keep interest rates lower than they might otherwise be.

Alternatively, they can seek to dial back QE, which would require a delicate balance and clear communication to avoid unnerving market participants still mindful of the 2013 “taper tantrum,” a selloff triggered by signals from the Fed that it would reduce monthly asset purchases.

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The task facing monetary policy makers is further complicated by the continued need to support the economic recovery. Global debt was forecast to peak at 267% of gross domestic product at the end of 2020 and is set to remain elevated as governments continue issuing debt to fund critical recovery measures.

Central banks have been a cornerstone investor in many transactions, providing governments and (to a lesser degree) corporate firms with the certainty of low-cost financing.

The elephant in the market

Because central banks’ sovereign-debt purchases are unlikely to change in the medium term, their holdings will increase further. In Europe, the stock of long-term government bonds outstanding has increased by about 25% since 2015 but the free float, or publicly tradable portion, has fallen, owing to the sharp increase in the ECB’s bond holdings.

Although the ECB will not suddenly start to divest its substantial portfolio and send prices downward, concentrated bond ownership could negatively affect market structure and liquidity. This is already evident in the European covered bond market, where the ECB now holds about one-third of all eligible bonds outstanding.

A lower market free float could reduce the number of active investors, increase volatility, and reduce price discovery in future periods of stress. Consequently, a true picture of liquidity and financing conditions in certain markets will probably emerge only if and when central banks start to scale back their portfolios.

Global investors have benefited from central banks’ stabilization of credit markets, and there have been fewer pandemic-related defaults to date than many participants initially feared. But low interest rates and sustained monetary stimulus have made it difficult for fixed-income investors to generate target returns, with approximately 90% of global bonds trading at a yield below 2% at the end of 2020. Recent yield-curve steepening has provided some respite, but central banks’ support remains critical to the global economic recovery—and the longer it remains in place, the more it may imperil fixed-income returns.

Consequences for pensions and investors

Lower fixed-income returns have obvious consequences for pension funds and future retirees, while investors are also chasing higher yields by taking on new and longer-duration risks, or increased credit risks, which ultimately could destabilize the system that central banks worked so hard to bolster. Leveraged loan issuance by B-minus rated borrowers has risen to a record high, according to a February report by S&P Global Market Intelligence, while borrowing costs have fallen to their lowest point since the 2008 global financial crisis.

Central banks are clearly not responsible for today’s investment decisions, but the longer their market support continues, the riskier the search for yield may become. Monetary policy makers and credit investors alike are facing an unenviable dilemma.

Patrick Drury Byrne is senior director and cross-practice sector lead at ?S & P Global Ratings. Sylvain Broyer is chief EMEA economist at S&P Global Ratings.

This commentary was published with permission of Project Syndicate—Central Banks’ Taper Dilemma.

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