Financial markets’ volatility depends a lot on the actions of central banks. Monetary policy decisions affect the way investors value financial assets and perceive them in the future.
Ever since deflation showed how much it can affect an economy (e.g., Japan), monetary policy tools changed across the world. Before the 2008 financial crisis, the most central banks did was to increase or decrease the interest rate level based on inflation and, in some cases, job creation.
However the 2008 crisis emphasized the weak spots in the system. Central banks were caught on the lower boundary of their interest rate levels, and additional measures were needed. The Fed in the United States led the way, as usual – it engaged in the process of Quantitative Easing (buying its government bonds or debt) with the net result of expanding the Fed’s balance sheet.
Balance Sheet Expansion – A Worldwide Phenomenon
The process was quickly viewed as a success and embraced by all other G10 member countries – some earlier, some other later down the road. But they all joined on the QE wagon, increasing their balance sheet.
To the surprise of many, if we compare the central banks’ balance sheet as a % of their respective country/region GDP, the Fed is not leading the pack. The Swiss National Bank (SNB) is the de-facto leader, closely followed by the Bank of Japan (BOJ) and the Bank of England (BOE).
During Janet Yellen’s Chair mandate, the Fed tried to reverse course on its balance sheet expansion. In the words of Yellen, the move was expected to be “boring”, just as “watching an oil paint dry”.
According to Guggenheim Investments, the Fed will need to conduct another $2 trillion of QE this year alone to cover the deficit. The danger here is that we know QE worked for the first time (in the aftermath of the 2008 financial crisis), but there is no guarantee it will continue to work at such a pace.
If market participants lose faith in the ability of the Fed to make QE work, the danger is that the stock market and corporate credit will suffer by secondary effects.
There is a saying that there is no investment without risk. Long-considered risk-free investments, Treasuries may turn out to redefine the concept sooner rather than later.