Investment Note - Not quite the end of quantitative easing


As expected, the US Federal Reserve (the Fed) announced an end to its quantitative easing (QE) bond-buying programme. With short-term interest rates already at zero, the Fed first employed QE in the wake of the 2008 credit crisis to improve banks’ balance sheets, unfreeze credit markets, stabilise the US economy, improve confidence and reduce long-term interest rates to help the property market. QE was also aimed at supporting asset prices and the wealth effect on spending.

It involved creating cash reserves by purchasing bonds from banks. The banks would then have the capacity to lend money to consumers and businesses. Mostly, they didn’t and the excess reserves created were parked with the Fed.

A second round of QE (QE2) was launched in 2011 and a third round in September 2012 with purchases of $40 billion a month of mortgage bonds. By December 2012, a further $45 billion of government bond purchases was announced. These three rounds of QE caused the Fed’s balance sheet to expand to $4.4 trillion. Fears that this surge in the monetary base would lead to runaway inflation proved to be completely unfounded. In fact, inflation remains below the Fed’s 2% target and recent commodity price weakness suggests inflation could remain below that target for a while still.

No market tantrum this time

In May 2013, the Fed hinted that it might start reducing the pace of its monthly purchases, setting off a severe market reaction that became known as the “taper tantrum”. Bond yields rose rapidly, especially in emerging markets, and equities wobbled. In January this year the Fed began tapering purchases by $10 billion a month. In part due to the taper tantrum, the Fed has been very careful in signaling its intentions as far as possible to avoid surprising the market. The end of QE was therefore entirely expected and priced in.

Importantly, the Fed will not sell off the bonds it has purchased already. So, while it is no longer active in the market, the Fed has still more or less permanently reduced the stock of outstanding bonds available for purchase. This should continue to keep bond prices up and yields low. Importantly, the Fed confirmed last week that short-term interest rates will remain low for a “considerable time.” Therefore monetary policy is still supportive, with rates only set to rise mid next year, depending on the strength of the US economy. The Fed did not pay much heed to the market turmoil of the past few weeks and rightly so. Underlying conditions in the US economy are improving as confirmed by third quarter economic growth of 3.5%.

The Fed ends but QE lives on

One accusation is that QE has pushed up equity prices, and that the end of QE3 will lead to prices falling again. Equity prices did fall after QE1 and QE2, but that probably had more to do with a weak economy. The US economy is certainly in a much better shape now than at any point during the past six years. For one thing, unemployment has fallen from 10% to below 6%. But the US economy is far from healthy in absolute terms, begging the question of how well QE has worked. It is very hard to know what the US and the global economy would have looked like without QE. The state of Europe, where unemployment remains stubbornly high and outright deflation is still a real risk, offers one answer. The European Central Bank (ECB) never embarked on QE (though it did launch a few rounds of cheap financing for banks). An important and often overlooked element of QE in the US is that it somewhat offset the impact of very harsh fiscal tightening. In Europe, the ECB did fairly little to minimise the damage caused by sharp cutbacks in government spending. The ECB is expected to start buying corporate bonds in December, but might still be forced to buy government bonds later on.

Another major central bank, the Bank of Japan, surprised markets on Friday by announcing that it would step up its own QE programme to ¥80 trillion per year in order to get closer to reaching its target of 2% inflation.

Chart 1: US Bond yields and equity prices during the third round of quantitative easing 


Lower inflation is the only good news

Data on inflation, job creation, credit and trade painted a mixed picture of the South African economy, highlighting the dilemma faced by local policy makers. On the fiscal policy side, the Finance Minister had little choice but to cut spending to slow the rate of government borrowing despite the short-term impact on already low growth. Failure to do so now would only lead to a much harsher adjustment later on. On the monetary policy side, consumer inflation is close to the upper end of the 3% - 6% target, but fairly well-behaved partly due to the weakness of the local economy. The SA Reserve Bank (SARB) appears to focus on external developments instead. Our large current account deficit needs to be funded with foreign capital, the flow of which could be severely interrupted with the prospect of increasing US interest rates next year. Balancing all these factors implies a very gradual interest rate hiking cycle.

The local economy is barely creating jobs

Unemployment remains dire. StatsSA’s quarterly labour force survey showed that the unemployment rate fell marginally to 25.4% in the third quarter with the net creation of 22 000 jobs. This includes the creation of 88 000 formal jobs, 28 000 informal jobs, 3 000 agricultural jobs, but the loss of 110 000 private household jobs (domestic workers and gardeners). In South Africa, 15 million people are employed and 5.1 million are unemployed. The ranks of discouraged jobseekers, who are not included in the official unemployment number, grew by 95 000 to 2.5 million.

Credit growth still very slow by historical standards

Private sector credit extension growth slowed to 8.7% year-on-year in September from 8.8% in August according to the SARB. Third quarter credit grew by 6.4% quarter-on-quarter (annualised), down from 8.7% in the second quarter.

Corporate credit growth has remained relatively strong on an annual basis for a number of months and rose by 15.2% year-on-year. According to the SARB, corporate credit has been dominated by the agricultural sector, renewable energy investments and the wholesale and retail trade sectors. Third quarter corporate credit grew by 18% quarter-on-quarter (annualised), up from 14%. In contrast, household credit growth slowed further to 3.6% year-on-year, significantly slower than the consumer inflation rate in August. Household credit growth has been on a downward trajectory since late 2012 as the unsecured lending boom has fizzled out. Mortgage credit growth slowed marginally to 3.3% year-on-year and remains weak overall. Third quarter household credit grew by 1.9% quarter-on-quarter (annualised), down from 2.7% in the second quarter. There is little reason to fear that a credit-driven increase in spending could push up inflation.

Price pressures easing at producer and import level

Producer inflation and import price numbers by StatsSA confirm that inflation is decelerating locally. Producer inflation fell to 6.9% year-on-year in September from 7.2% in August. Food inflation at the factory level receded further from 7.9% in August to 7.1% in September, although meat prices rose at a faster pace. Food price inflation at the farm level is also falling, but again, meat prices are rising faster while grain prices are falling. In terms of the overall food price pipeline - from farm to factory to shop – slower growth is good news for consumers. In terms of import prices, it also appears that the impact of rand weakness is fading. Import prices rose by 17% year-on-year in August from 19% in September. Aside from basic metals, import price inflation was lower across all categories of goods. Notably, petroleum import prices rose by 17.2% in the year to August, slower than the 19% growth rate posted in July.

Trade deficit still large

September trade data from the South African Revenue Service (SARS) showed a trade deficit of R2.91 billion including Botswana, Lesotho, Swaziland and Namibia (BLNS countries) on exports of R90.79 billion and imports of R93.71 billion. Exports increased from August to September by R14 billion (18.2%), including a R4.8 billion month-on-month increase in precious metals as platinum production slowly gets back to normal. Imports only increased by R0.17 billion (0.2%) from August to September. Excluding the BLNS countries, which we have a persistent trade surplus with, the deficit was R12.64 billion in September.

On a cumulative basis (first nine months of the year compared to the same period last year), exports rose by 7.3% and imports by 8.1%. While the increase in exports is encouraging, the fact that imports are increasing faster means the trade deficit remains stubbornly large. 

Chart 2: SA trade balance (including BLNS countries)