Richard Jerram, Chief Economist, Bank of Singapore Member of OCBC Wealth Panel

October marks the next stage of policy tightening in developed markets as central bank balance sheets start to contract. This marks another small step down the long path of normalisation after the crisis of a decade ago and, so far, the process has not involved any serious disruption to major economies or financial markets.

Global Financial Crisis a decade ago meant that even tough central banks cut interest rates to zero this was not enough to drive recovery.

As a result, many turned to expanding their balance sheets (labelled “quantitative easing” or “QE”) in order to support growth. The effectiveness of QE is controversial. It reduces the supply of government bonds in the market, and hence pulls down yields, while also signalling the central bank’s commitment to pursuing loose policy for a lengthy period. More vaguely, it is also seen as boosting liquidity, although this is rarely defined very precisely.

There might be some self-fulfilling expectations, where if people think it will work, then it works.

After a decade of ever-expanding QE, September marked a peak. From October, the combined balance sheet of central banks in the US, Eurozone and Japan will start to shrink.

The Fed ended QE back in 2014 and a year ago went into reverse with quantitative tightening (QT). It has been gradually stepping up the pace and it will reach maximum velocity of $50bn balance sheet shrinkage per month from October.

At the same time the ECB will cut back its monthly asset purchases from €30bn to €15bn ($17bn), before halting altogether at the end of the year. The balance sheet will not start to shrink until some time after the first rate hike, which is set to be 3Q 2019. Japan has been targeting bond yields rather than a specific amount of bond purchases for the past couple of years. Its QE looks set to run at a $20-30bn monthly pace; much slower than a few years ago.

Put together it means that the combined balance sheet starts to shrink from October. The pace of decline will accelerate in 2019 once the ECB ends QE altogether.

How much does this matter? Remember that we had predictions of doom ahead of the Fed’s first rate hike in December 2015 and again before QT started a year ago, but the impact has not been dramatic. Overall, it looks like a fairly orthodox tightening cycle, albeit much slower than usual.

Another reason for calm about QT is that policy intentions have been signalled well in advance – we can make a good guess about where balance sheets will be at the end of next year.

At some point the Fed will discuss when it should stabilise its balance sheet, but QT looks set to run into 2021 – unless it is interrupted by recession.

However, just because markets can see what is coming does not mean they are unaffected by it. Empirical studies suggest every $100bn expansion of the Fed’s balance sheet brought bond yields down by 2-3bp. If a “normal” balance sheet is about $2tr below the peak, then that points to a possible rise in yields of 40-60 basis points, some of which will have happened already. Flows from QE in Europe and Japan have probably also contributed to lower US yields, and that is set to fade.

As QT turns into a headwind for US Treasuries, together with the pressure from continued Fed rate hikes and the ballooning budget deficit, we see 10-year yields pushing up to 3.5% over the coming year.

There is also the question of whether all QE is equal. The USD plays a dominant role in global financial markets and a dollar’s worth of QE from the Fed seems to have more impact than the equivalent amount from the ECB or BOJ. Remember in 2013 the BOJ under new Governor Kuroda embarked on a radical policy to fight deflation, soon followed by Fed Chair Bernanke’s hints of an early end to QE. The ensuring “taper tantrum” showed that markets put much more emphasis on US policy. It might be that the ECB ending QE and the BOJ reducing purchases is less significant than the Fed’s QT, which is already well-underway.

The overall picture is that shrinking balance sheets are being accompanied by rising interest rates across a broadening range of developed markets. Policy is still loose, but it is tightening, albeit very slowly and cautiously. This is significant after a decade of easy money, but the first steps from the US have shown that it does not have to overly disruptive to economic growth or financial markets.