HSBC Explains How Markets Will Behave in a World of 'Quantitative Exhaustion'
Unconventional monetary policy has passed its best-before date, according to economists and strategists at HSBC.
They argue that the failure of the extraordinary stimulus deployed in the wake of the financial crisis can be demonstrated by the sugar high, rather than sustained lift, these actions gave to market-based measures of inflation expectations:
"We have reached the point of diminishing returns, so much so that if global growth disappoints, policymakers will need to consider a number of options," they conclude, deeming the market to be at "the point of quantitative exhaustion."
To this end, Global Chief Economist Janet Henry, Chief European Economist Karen Ward, Global Head of Fixed Income Steven Major, and Strategist Subhrajit Banerjee pose and answer two questions:
What are the options if the global economy—and even the U.S.—can't handle any degree of normalization and policymakers are forced to add more stimulus? And How will the bond market react?
Many of these options, they note, could happen in conjunction with one another, with the policy mix making it more difficult to discern the potential reaction in sovereign debt markets.
One course of action would be to double down on bond-buying programs known as quantitative easing. But not only would doing the same thing over and over and expecting a different result be insane, to paraphrase Einstein, but there are also central banks rubbing up against technical constraints under the structure of their ongoing asset-purchasing programs.
"The BoJ, with a commitment to continue expanding the monetary base at a rate beyond new issuance, will at some point exhaust the entire JGB market. If it adheres strictly to its current modalities, the ECB will hit technical constraints at a much smaller purchase programme because of European-specific issues surrounding the capital key and collective action clauses (CACs)."
Major and Banerjee indicated that expanded QE would first likely result in a steepening of the yield curve, then a flattening as optimism gives way to disappointment.
In the event that QE's lack of transmission to the real economy becomes clear, fears of global deflation could spur a rush into safe-haven assets and a flattening of yield curves.
A second option would be to refuse to let the zero lower bound bind and cut policy rates into negative territory. Several central banks in Europe have gone down this road, with the ECB seemingly poised to lower its deposit rate further into negative territory in the near future.
There are potentially perverse side effects to this policy and, under the prevailing monetary regimes, a floor on how low rates could actually go.
Negative policy rates typically translate into lower yields further down the curve, albeit with a quite limited impact on longer-dated debt.
HSBC's fixed income strategists see the potential for a "banana effect" as negative rates are enacted, in which the front end of the curve flattens while the longer end steepens.
But if monetary easing offers fewer and fewer benefits, as HSBC claims, the alternative route warrants greater consideration.
Strong demand for fixed income and, in most cases, the ability to print their own money means debt capacity constraints for national governments might be higher than ever imagined. As the economists note, fiscal policy is "potentially the only unlimited tool" to boost growth and inflation.
"Governments should focus on projects that would ease private sector bottlenecks and encourage business activity. This is the type of government spending that is most likely to boost GDP and tax receipts, in turn paying for itself," they said.
History suggests that increased issuance to fund this expansionary fiscal policy would tend to steepen the curve, according to Major and Banerjee.
If a government and central bank were sufficiently ambitious—or desperate—they could turn to "helicopter money" to rejuvenate the economy. That is, central banks could directly monetize government debt, which would be used as stimulus via public works programs or direct transfers to citizens.
"Even in a report that is considering the various future policy options that could be considered in the event of further nominal growth disappointment, we put this in the category of something that would only be considered in the event of a sudden panic or collapse in activity," Henry and Ward cautioned.
In the event that this radical step were taken, the interest rate strategists believe that there would be a knee-jerk move higher in inflation expectations and risk premium, prompting a selloff in bonds.
The final possibility—and the most depressing of the bunch—is that policymakers simply give up on stimulus.
"When there is not a strong enough consensus in governments and central banks to pursue new policies, especially because the previous radical policies like QE were so controversial, the risk is that nothing will happen," wrote Major and Banerjee.