Bernanke's great trial at the beginning of the end

If the mere raising of the prospect that the US Federal Reserve Board might ‘’taper’’ its $US85 billion a month of bond and mortgage buying could cause the kind of volatility experienced in financial markets in the past few weeks what might happen when the Fed does start winding back its quantitative easing program?

There is clearly a debate within the Fed about the future of the program that has yet to be resolved. Equally there is a debate outside the Fed about the impact on markets – bonds, currencies, equities – if and when it does start to wind back its purchases. The unconventional policies pursued by central banks in the key advanced economies has forced down risk premia and pushed up the value of risk assets.

Some are quite sanguine, putting their faith in Ben Bernanke’s ability to finesse the process over time without overly disrupting markets. Bernanke has made it pretty clear there won’t be an abrupt end to the program.

Others aren’t as sure of the Fed’s ability to manage the market’s response to the beginning of the end of the extraordinary expansion in the Fed’s balance sheet and an era of significantly negative real interest rates in the US, Europe and Japan. The gyrations in markets last week tend to bolster the sceptics’ case.

Last weekend the general manager of the Bank of International Settlements, Jaime Caruana, gave a speech in South Korea in which he talked about global liquidity and the global ease of finance and the role that central banks have played by bidding up bond prices and pushing yields down.

Central banks in the advanced economies had vastly expanded their balance sheets, from about $US4 trillion before the financial crisis to about $US10 trillion today, he said.

The large-scale purchases of bonds by major central banks had pushed nominal bond yields down relative to prospective nominal GDP growth and produced very unusual bond market pricing, where instead of being paid a term premium for holding fixed rate bonds investors were actually paying a penalty.

‘’The very success of pushing the term premium down into negative territory has created the risk of its sudden rise, even if central banks succeed in communicating their intended paths for short-term policy rates. A global steepening of yield curves could hit the capital of financial institutions, to the extent they hold their government’s debt, and worsen debt sustainability,’’ he said.

That adds a dimension to the discussion about the exit of QE-style programs.

The risk of a bond market meltdown when central banks start winding back these programs has been canvassed widely, as has the impact on the multitude of carry trades being run off the back of ultra-low interest rates and an expectation that the Fed will manage an orderly withdrawal from its program (an expectation challenged in recent weeks by the behaviour of markets since the prospect of an early start to tapering of the program was raised).

In his speech Caruana made the point that the total debt of G20 countries was 30 per cent higher today than it was at the start of the financial crisis and that households and firms in the economies most affected by the crisis had adjusted their balance sheets less than might have been expected.

In Europe overall private debt had barely fallen in relation to GDP while public indebtedness continued to rise. In other words, five years after the crisis began, not a lot has been done to shore up the most vulnerable system, one in which the relationship between banks and government creates a feedback loop that has been positive while rates have been falling but could as easily become destructive if rates were to move in the other direction.

The raises the prospect that any withdrawal from QE programs would have not just an impact on financial markets, which could be quite traumatic if the normalisation of the term premium were to occur abruptly, but could also ignite another European (and perhaps Japanese) set of related sovereign debt and banking crises that might be even more difficult to respond to than the 2008 crisis.