Quantitative Easing

Quantitative easing is becoming a common term from now onwards, especially markets begin to realize the limitation of central banks in lowering interest rates. This is very much seen as unconventional policy measures, which rather than encouraging but forcing changes in market prices and volume.

In short, quantitative easing can be seen either in terms of supplying an even greater ‘quantity’ of money that would be required to keep the overnight rate at o% or in terms of targeting interest rates further out the maturity spectrum. Beyond that we already see the widening collateral eligibility, unlimited US dollar funding and ways in which liquidity is injected. In fact, Bank of England went beyond this by establishing the Special Liquidity Scheme, which allows banks to swap MBS for US Treasury bills, renewable for up to three years.

In 2001-05 experience, Japan had a specific target for the quantity of excess bank reserves as part of its attempt to convince market players that it would hold short rates at zero for as long as necessary to bring the economy out of deflation. The main instrument to inject liquidity was the purchase of commercial bills on repo basis, rather than outright purchase of long-term JGBs. Of the 48 trillion yen increase in monetary base between Mar01 to end 2005, the commercial bill repo accounted for almost 71%.

In recent experience, we have seen much more variance of quantitative easing, including a sharp expansion of the central banks’ balance sheet as private sector financing mechanism are replaced, possibly that with a non-standard approach to the financing of the government debt and an exchange of assets such as the quality of the central banks’ balance sheet deteriorates. At some point, the distinction between fiscal and monetary policies can become blurred.

Under this circumstance, the government’s intervention may become a stronger influence on the shape of the yield curve than private sector flows and that potentially will break the curve from its normal relationship with the level of short rates. Recognizing that the same effect will force a change in duration and convexity hedging strategies as traditional relationships break down.

Within FX itself, it could undermine carry and real interest rate spreads are becoming more important. It forces players to focus on relative changes of base money as well as the sustainability of financing flows. As we are experiencing greater quantitative easing, currencies with a record of protecting against inflation as well as those with a low level of combined public/private debt will be the preferred ones.