Quantitative easingWhat central banks do when rate cuts run out.
When cutting rates is not enough, central banks create money to buy bonds. That lowers yields, weakens the currency and lifts stocks and gold, and the tone of central bankers often gives it away early.
Money created to buy bonds
The key interest rate is a central bank’s first tool. Once rates are already very low, cutting further does little, so central banks reach for a second one: quantitative easing, or QE. The central bank creates money electronically and uses it to buy government and company bonds in very large amounts.
That buying does 2 things at once. It pushes a huge amount of new money into the financial system, so the money supply rises. And because the central bank becomes the biggest buyer in the market, bond prices rise and their yields, the interest they pay, fall. Traders often simply call it money printing.
Central banks use QE in the same situations in which they cut rates: to fight a recession, or when inflation is too low or prices are falling. The aim is to push inflation and growth back up.
A weaker currency is part of the plan
When there is suddenly much more of a currency around, its value tends to fall, and the pressure can last for years while the bond buying continues. Central bankers know this, and they count on it. A weaker currency makes the country’s exports cheaper abroad, which helps its companies sell more.
It also makes imports more expensive. Together with the extra money in the system, dearer imports push prices up, which is exactly what a central bank fighting deflation wants. When eurozone prices were falling in the mid-2010s, the ECB bought government bonds and later company bonds on a large scale, and the euro weakened as the ECB’s holdings grew.
What QE does to markets
The effects follow a familiar pattern. Bond yields fall, because the central bank keeps buying. Stocks usually rise, because bonds now pay less, money goes looking for better returns and companies can borrow cheaply. Real assets such as precious metals and property are in demand, because paper money is losing value.
Japan shows how far it can go. The central bank’s bond buying pushed the yield on 10-year government bonds below zero, so investors were in effect paying the government to hold their money. In the US, the Fed’s bond buying from 2008 went hand in hand with a long rise in gold, a story the lesson on gold and oil follows in detail.
Hear it coming
Central banks rarely surprise the market completely. Their public statements give clues before a decision, and the tone is what to listen for. Hawkish means leaning towards higher rates and tighter money. Dovish means leaning towards cuts, easier money and, at the extreme, bond buying.
The tone usually shifts before the policy does. A central bank that starts to stress weak prices and its readiness to use every tool is preparing the market for easing. One that starts to talk about scaling back its bond buying is preparing it for the opposite. Yields and the currency often start to move on the hint, before the first bond is bought, so the speeches listed in the Economic Calendar deserve as much attention as the decision.
The end of QE matters as much as the start. Once the market expects the bond buying to end, much of the chain tends to run in reverse: yields rise and the currency firms, often before the central bank confirms it. After 2011, as the end of the Fed’s easing came into view, the dollar firmed and gold fell back.
Easier money ahead
- Worried about weak prices or growth
- Rates to stay low for longer
- Ready to use every tool
- Bond buying on the table
Tighter money ahead
- Worried about high inflation
- Rate hikes on the table
- Bond buying to be scaled back
- Points to strong jobs and wages
In short
- With QE a central bank creates money electronically and buys government and company bonds, which raises the money supply and lowers bond yields.
- The currency usually weakens on purpose, while stocks, gold and property tend to gain because paper money is losing value.
- The tone of central bankers shifts before the policy: hawkish leans towards tighter money, dovish towards cuts and bond buying.
Questions
Is QE the same as printing banknotes?
Not quite. The money is created electronically and used to buy bonds, so it reaches the economy through the financial system. The effect is similar, which is why traders call it money printing.
Does QE replace rate cuts?
It usually comes on top of them, once rates are already very low. Both point the same way: more money and a weaker currency.
Key terms
- Quantitative easing (QE)
- A central bank creates new money to buy bonds. It pushes yields down and adds money to the system, which usually weakens the currency.
- Money supply
- The total amount of money in an economy. More money chasing the same goods tends to push prices up.
- Bond yield
- The return an investor earns on a bond. Yields rise when bond prices fall. Short-term yields follow rate expectations, long-term yields follow inflation and growth.
- Hawkish and dovish
- Hawkish: a central bank leans towards higher rates to fight inflation. Dovish: it leans towards lower rates to support growth.
- Recession
- A period in which the economy shrinks instead of growing, usually with rising unemployment.
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.