The QE unwind in action

We have seen some of this rise already as QE has started to unwind. But we have also seen a pickup in inflation, stronger growth and a tightening in monetary policy. One can therefore infer there is more to do.

Investor behaviour is very interesting. Credit spreads, which have compressed significantly across asset classes, are now widening – although some would argue they can’t widen much further while the macro environment remains supportive. Funding markets have become more challenged lately.

To borrow a line from the Reserve Bank of Australia, investments made at very low yields will look extremely different as yield rises. This is both a monetary policy and a QE issue – so as these unwind and as the European Central Bank (ECB) moves towards this, potentially later this year, the landscape will start to transform quite significantly.

The more important factor is that there will be a cyclical uplift in yields. Central-bank balance sheets will become smaller as a consequence of the unwind but I expect this will be a very gradual process. I also believe yields will be significantly lower than we have seen in prior cycles.

Yields have backed up in the Eurozone but this is part of a global context as US yields have also increased. Real-money investors remain desperate to buy at any backup in yield and at the same time pricing on double-A rated or lower credit continues to tighten. Investors are buying at ridiculously tight credit spreads right now.

When QE began we expected to lose more investors than we finally did. We lost some international buyers through the negative rates environment but we also discovered that euro investors are surprisingly sticky.

At the same time, as euro funders we achieved very attractive funding costs. The recent uptick in yield made other markets look more attractive. We have already issued in 10 currencies since the beginning of 2018.

The QE programme led to a distortion in spreads between supranational and agency issuers, but this has also normalised now. This is a healthy development for the market.

Obviously, having a new big buyer in secondary was supportive of liquidity. But I never heard any complaints about liquidity in KfW bonds even before this.

Having said this, the regulatory backdrop has changed. It is harder for banks to warehouse risk than it was pre-QE. In this environment, with fewer buyers in the market, bonds will settle by price – bearing in mind yields are lower but still cyclically higher than where they were.

It is difficult to say whether this is a consensus view. Current commentary focuses around whether we are at the beginning of a bond bear market. Personally I am not convinced, because many of the fundamental factors – namely low inflation and a large output gap – that necessitated QE are still in play. Substantial progress has been made to narrow the output gap, but unemployment remains high in Italy, France and Spain.

It will be a long process to the final unwind. Let’s not forget that at some point the ECB will begin to reinvest – so even when QE ends a lot of stock will come back into the system.

Last year we observed considerable interest from investors with a natural need to hedge against inflation – for example from insurers. But this has somewhat abated now given inflation is gradually moving higher.

There is an opportunity for investors if break evens in 10 and 20 years narrow below 2 per cent. This is cheap and provides an option for the future.

The ECB has had many similar thinkers for a long time. Perhaps some diversity is needed.

But something has to give in the Eurozone. The Brexit negotiations have demonstrated the difficulty a country that was not even part of the single currency has in trying to leave the economic bloc, so leaving the Eurozone is not really an option.

However, German politicians will find it difficult to accept a ‘Germany-pays’ attitude. There are structural issues in the Eurozone and we must either make progress on the project or leave it for good.

Markets remained stable through the Italian election and other event-risk scenarios, which demonstrates that confidence is high in the region. Even though the UK is making it quite tough for Europeans to agree on exit conditions, I actually think the UK’s departure will in the end bring the rest of Europe closer together.

There isn’t an obvious Greece catalyst right now. The first can is probably Brexit and, as Petra Wehlert points out, the UK’s exit probably strengthens Europe for those that stay in.

We can achieve competitive levels in Australian dollars relative to the long end of the euro curve, and this is where the investor demand currently is. From this perspective a QE unwind stance can only help.

In the shorter end, we see very attractive funding in US dollars because of negative rates in euros. If this also normalises, it too could support the Australian dollar market.

Looking longer term, Australian dollar demand has always balanced domestic and international interest. It forms part of nearly every central-bank portfolio. Therefore, the Australian market is very much a success story. Even in a shrinking environment we issue A$2.5-3 billion per year.

What does QT mean for this relative equation? On one hand, with yields rising and liquidity normalising, one should expect the euro-US dollar basis swap to tighten and Australian dollar funding to become less affordable. However, QT should also increase our euro borrowing costs.

It is a fairly complex arbitrage equation with many moving parts – including how much the Australian major banks fund offshore. Major-bank issuance in offshore currencies clearly affects the level of the cross-currency basis swap and the hedged cost of funding for the SSAs. Quite frankly right now it is a bit of a guessing game.