Jeremy Sterngold, Head of Fixed Income
Conventional wisdom tells us that by investing huge sums of money into limited financial products causes the prices of those assets to rise sharply. Once prices reach unsustainable levels, invariably this results in sharp price declines for those inflated assets. Indeed, using history as a guide, there have been a number of incredible bubbles formed in this way, such as the Tulip Mania in the 1600s, the South Sea bubble in the 18th Century, and more recently, the tech bubble in the 90's. Given the enormous scale of quantitative easing (QE) that central banks have deployed in order to help economies through the pandemic, can we expect the same to occur?
The very question we are addressing was asked to the Chairman of the Federal Reserve (Fed), Jerome Powell, on Wednesday following the conclusion of the Federal Open Market Committee. Given the recent changes to its objectives regarding inflation and full employment, it was no surprise that this meeting offered no further shift in policy. Chairman Powell stated that the period between the last recession, brought about by the financial crisis, up to the pandemic marked the longest uninterrupted expansion in history for the US economy. The economy did not suffer a downturn because of any bubble bursting, but rather an exogenous shock. His rebuttal to that question indicated that the conventional wisdom we took at face value may not apply here. Why is that?
The asset purchases made by the Fed are mostly concentrated in assets that are not limited in nature. Central banks have primarily bought sovereign debt, where issuance has expanded rapidly, given the large budget deficits that governments have amassed in order to support the economy throughout the pandemic. This has helped keep government borrowing costs low, despite the enormous amount of supply. The money, however, has not flowed to 'Main Street', given that the financial crisis resulted in stricter lending standards for the banking space and thus prevented another big increase in sub-prime lending.
In addition, QE has had a 'crowding out' effect. This means that typical investors in government bonds have moved more towards investing in investment grade (IG) bonds, and typical IG investors have moved more towards junk bonds. This has in turn reduced the yield advantage, or risk premium, that normally applies to riskier asset classes. Whilst risk premiums have clearly been suppressed, one cannot yet argue that QE causes bubbles. Whilst asset prices have notably risen since QE became a permanent part of central bank policy, this has also been a function of cheaper borrowing costs. However, the side effects of ultra-accommodative monetary policy may indeed foster an environment for further bubbles to develop.
A noteworthy and recent example was that of Bitcoin in 2017. After starting the year around $1,000 per Bitcoin, the cryptocurrency surged to around $19,000, before falling to around $4,000 towards the end of 2018. Another place where we have seen a similar degree of euphoria has been in pre-IPO companies. As investors are always looking for the next big opportunity, valuations for companies developing new and exciting technologies have skyrocketed, even those that are still burning cash. Even though some of these companies have succeeded and flourished following their IPO, there have been a number of high profile failures, such as WeWork. As investors continue to seek higher returns in a low yield environment, given that QE has suppressed the broader credit risk premium, companies have been able to attract financing with fewer strings attached.
So, whilst QE on its own does not generally cause bubbles, it does foster an environment where pockets of smaller bubbles can easily develop.
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