(Aug 14): There has been quite a bit of talk and concern surrounding the US Federal Reserve’s rate hikes and their potential negative impact on equity markets. I believe these concerns are misplaced.

Instead, we need to be far more fearful of the imminent reversal of quantitative easing (QE) not just by the Fed but also the European Central Bank (ECB).

Take a look at the chart showing the fed funds rate and equity market performance. Between 2003 and 2008 (Phases A and B), the fed funds rate and the Dow Jones Industrial Average were positively correlated, that is, they moved in the same direction. They are affected by the same underlying factors, namely the health of the economy and corporate earnings growth.

In the aftermath of the global financial crisis, however, this relationship appears to have broken down. The main reason is distortions from unorthodox central bank actions.

In efforts to shore up confidence and stimulate flagging growth, central banks in developed markets resorted to bond buying programmes.

These QE actions injected massive liquidity, stimulating growth and driving up asset prices.

The primary reason for this unorthodox policy was that the traditional monetary tool of lowering interest rates was no longer effective, given that interest rates were already zero or near zero and the crisis was one of confidence and high household debt.

In the ensuing years (Phase C), we have had standing buyers in the bond market with unlimited funds and complete insensitivity to price and returns. The balance sheets for the Fed, ECB and Bank of Japan (BOJ) grew exponentially — from less than US$4.3 trillion at the beginning of 2008 to more than US$14.2 trillion ($19.3 trillion) currently.

Over this period, the Fed’s portfolio of bonds increased more than fivefold, from less than US$900 billion in 2008 to nearly US$4.5 trillion. That of the ECB more than doubled from a little over US$2.3 trillion to well over US$5.2 trillion now. A similar trend is seen for the BOJ.

Buying by central banks fed a multi-year bond rally, while yields for the highest-quality government securities were driven down to near zero, even into negative territory. Remember, bond yields fall as prices rise.

The massive liquidity spilled over into equity markets. With bond yields at historical lows, investors looked to stocks with high dividend yields and emerging markets for better returns. As they took on more risks, unlisted and private-equity deals mushroomed. Property prices from Vancouver to Melbourne have since risen to record highs.

Companies, for their part, were raising money through cheap borrowings to fund higher dividend payouts and buy back their own shares. The expanded gap between earnings and bond yields was justification for higher and higher stock valuations.

Stock prices have continued to rise (Phase D) even after the Fed started raising the benchmark interest rates — reverting to the positive correlation from before the financial crisis.

Once again, equities are being driven by a resurgent broad-based corporate earnings recovery as the economy continues to gain traction. The trillion-dollar question is what happens when central banks stop buying bonds and start shrinking their balance sheets.

The Fed has indicated that it may begin to allow a capped amount of maturing bonds to roll off without reinvesting the proceeds, as it is currently doing, as soon as September or October. The ECB hinted it would start winding down stimulus in 2018.

These developments are widely expected.

But most believe that the reversal would be slow and gradual. They want to believe that central banks can orchestrate an orderly exit.

In other words, they intend to keep partying until the music stops. But I can just as easily imagine a stampede out the door.

If I know the underwriters of deals — the central banks — are exiting, no matter how gradual, how carefully managed the exit, why would I want to hold on? And if many think the same, can bond prices hold?

Bond prices will fall and yields will rise — perhaps rapidly once the artificial pressure from central bank buying is removed. And the turmoil will not be limited to the bond market.

At a minimum, higher yields will make bonds attractive again as fixed-income investments — drawing money out of all those high-yielding stocks, which have been enjoying premium valuations, and emerging markets.

The same is likely to be true of unlisted and other asset classes.

Rising borrowing costs will hurt corporate earnings and expose cracks in highly indebted companies, particularly those that have borrowed cheaply and invested foolishly over the past 10 years.


Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

This article appears in Issue 792 (Aug 14) of The Edge Singapore