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IMF: Federal Reserve QE tapering could spark global rate rises IMF: Federal Reserve QE tapering could spark global rate rises
(about 9 hours later)
When the US Federal Reserve starts to phase out its $85bn-a-month quantitative easing programme it could spark a rapid rise in global interest rates and "fire sales" of assets across the world's financial markets, according to the International Monetary Fund. The International Monetary Fund has underlined the scale of the challenge facing Janet Yellen if she is confirmed as Federal Reserve chairman by issuing a stark warning on Wednesday that phasing out quantitative easing could spark "fire sales" of assets, wiping $2.3tn off bond markets.
In the latest edition of its twice-yearly Global Financial Stability Report (pdf), the IMF said markets have become riskier over the past six months as investors have begun to adjust to the prospect of an end to QE in the US. In the latest edition of its twice-yearly Global Financial Stability Report (pdf), the IMF said markets had become riskier over the past six months as investors began to adjust to the prospect of the withdrawal of the Fed's $85bn-a-month programme. Under its "adverse scenario", the fund warned, global interest rates would jump abruptly, causing turmoil across world financial markets.
Its analysts laid out a relatively benign scenario, in which market interest rates adjust gradually to a world without the flow of cheap money from the Fed. Yellen is widely seen as a monetary-policy "dove" who will be reluctant to rush into turning off QE, and her appointment cheered markets, which have thrived on the flow of cheap funds from the central bank's bond-buying spree. But the Fed has clearly signalled its intention to scale back the pace of its asset purchase programme once unemployment falls below 7%.
But they warned that there is also an "adverse scenario", which would involve investors taking a $2.3tn (£1.4tn) hit amid "a rapid tightening in financial conditions, potentially aggravated by reduced market liquidity and forced asset sales". The IMF regards the phasing out of QE as a positive development, reflecting the growing US recovery, but the report warns that "managing a smooth transition could prove challenging, as investors adjust portfolios for a new regime with higher interest rates and greater volatility".
The IMF describes the markets' so-called "taper tantrum" earlier this year, after the Federal Reserve chairman, Ben Bernanke, mooted the idea of tapering QE, as a "mini stress test", which helped to reveal how investors might respond as monetary policy returns to normal. Presenting the report in Washington on Wednesday, José Viñals, the IMF's director of monetary and capital markets, welcomed Yellen's likely appointment, saying, "I cannot think of anybody who's better placed than Janet Yellen to lead the Fed in these challenging times".
Its adverse scenario involves the same increase in long-term interest rates – one percentage point – as the benign scenario, but over a much shorter time-period. In the report, IMF analysts lay out a relatively benign scenario in which market rates adjust gradually as the Fed withdraws its stimulus. But they warn that there is also an adverse scenario, which would involve investors taking a $2.3tn (£1.4tn) hit amid "a rapid tightening in financial conditions, potentially aggravated by reduced market liquidity and forced asset sales". The IMF described the markets' so-called "taper tantrum" earlier this year, after Fed chairman Ben Bernanke mooted the idea of tapering QE, as a "mini stress test" that helped to reveal how investors might respond as monetary policy returns to normal.
Because investors have flooded into bond markets and longer-term assets since QE has been under way, the losses to investors would be far larger than during other recent episodes when policymakers have been pushing up interest rates – $2.3tn, compared with the average of $664bn over the past three tightening cycles. Its adverse scenario involves the same increase in long-term interest rates – one percentage point – as the benign scenario, but over a much shorter time period. Because investors have flooded into bond markets and longer-term assets since QE got under way, the losses to investors would be far larger than during other recent episodes when policymakers have been pushing up interest rates. Losses have averaged $664bn over the past three tightening cycles. Andrew Haldane, the Bank of England's executive director for markets, recently warned that central banks had inflated "the biggest bond bubble in history", which could jeopardise l stability if it burst.
Andrew Haldane, the Bank of England's executive director for markets, recently warned that central banks had blown "the biggest bond bubble in history", and highlighted the risk that it could burst. The IMF highlighted the fact that some parts of the less-regulated shadow banking sector, such as mortgage real estate investment trusts, are particularly vulnerable, because they are heavily reliant on short-term borrowing from the so-called repo markets, which can dry up in times of financial stress. "Short-term secured funding markets are still exposed to potential runs that a rising-rate, higher-volatility environment may reveal," the report said.
The IMF highlighted the fact that some parts of the less-regulated shadow banking sector, such as mortgage real estate investment trusts, are particularly vulnerable, because they are heavily reliant on short-term borrowing from the so-called repo markets, which can dry up in times of financial stress. Viñals pointed out that capital flows to emerging markets have increased by $1tn since the collapse of US investment bank Lehman Brothers in 2008 – $500bn more than previous trends would have suggested.
"Short-term secured funding markets are still exposed to potential runs that a rising-rate, higher-volatility environment may reveal," the report said, calling for policymakers to monitor these institutions more closely. As the flow of cheap money is turned off, which could prompt many investors to pull their capital back home, he suggested policymakers may have to intervene in foreign exchange markets "in order to maintain orderly conditions".
Emerging markets may also face tough adjustments as markets respond to any change of policy by the Fed, according to the IMF's analysis. India, Indonesia and Brazil were among the countries that were forced to intervene to steady financial markets earlier this year during the taper tantrum, as investors withdrew funds from riskier developing countries. The IMF also remains concerned about the risks to financial stability in the eurozone, where many companies are still carrying heavy debt burdens. "In the stressed economies of Italy, Portugal and Spain, heavy corporate sector debt loads and financial fragmentation remain challenging," the report says.
José Viñals, director of the IMF's monetary and capital markets department, pointed out that capital flows to emerging markets have increased by $1tn since the collapse of US investment bank Lehman Brothers in 2008 – $500bn more than previous trends would have suggested. Help to Buy warning
He suggested policymakers may have to intervene in foreign exchange markets "in order to maintain orderly conditions". The IMF's José Viñals has reiterated the fund's scepticism about the UK government's Help to Buy scheme. "The question is, if the scheme we have increases the demand for housing but there is not a sufficient response on the supply for new housing, this may lead to even higher housing prices, which may actually reduce the affordability of housing to the population," he said, warning "one needs to be vigilant" about the impact on households and on banks' balance sheets.
The latest part of the scheme, launched this week, is intended to underwrite £130bn of mortgage lending on deposits as low as 5%. But Danny Alexander, chief secretary to the Treasury, dismissed concerns it will inflate a housing bubble, saying critics ignore areas of the country where house prices are not rising fast.
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