This is an audio transcript of the Behind the Money podcast episode: Why central banks are baffling investors

Michela Tindera
So there’s a part of the world’s financial system that’s sometimes known as its plumbing. And the FT’s markets editor, Katie Martin, says, that it’s not really quite as thrilling as something like, say, the stock market.

Katie Martin
Not, you know, 99 per cent of the time this sort of plumbing is just, it’s just super boring.

Michela Tindera
It’s the stuff that central banks do in the background of markets, the stuff that makes money flow around the global system.

Katie Martin
Like no, no person in their right mind who does not do this sort of stuff for a living, should be paying the blindest bit of attention to it.

Michela Tindera
For a long time, central banks, including the Federal Reserve, have been doing this thing in the plumbing called quantitative easing, or QE for short. QE is this process where central banks buy up predominantly government bonds in an effort to push down yields. The idea is that this will push the private sector into investing in other areas and eventually stimulate the global economy. But that whole process is changing now. Banks are shifting away from QE, and as it so happens, nobody really knows how this is gonna turn out.

Katie Martin
But plumbing, just like the plumbing in your house, when it goes wrong, it’s quite important, quite quickly.

Michela Tindera
And so now, after years of implementing quantitative easing, that is buying up bonds and other assets, now the banks are making a change. They’re moving away from QE and into something called quantitative tightening or QT. And while you might not have heard of QT yet, it’s a move that could have ripple effects out into all parts of the economy, from the stock market to the rate on your mortgage.

Katie Martin
So QT is one of those things that, look, if this all goes fine, then we can just pretend it never happened and move on to the next phase of our lives. If this goes badly, everyone is going to be talking about it.

Sound clip
(A pipe bursting and water leaking . . . water flow gradually stops after being tightened and hammered)

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Michela Tindera
I’m Michela Tindera from the Financial Times. On today’s episode of Behind the Money, will quantitative tightening help fight inflation, or will it cause markets to go haywire in the process?

Hi, Katie. Thanks for coming on the show today.

Katie Martin
Pleasure.

Michela Tindera
So central banks have a whole collection of tools available to them to support markets. And in 2008, when the financial crisis hit, they needed to use all kinds of tools to help the economy. So one thing they did was slash interest rates. But when that still wasn’t enough to get the job done, they also used this thing called quantitative easing. So how did that work exactly?

Katie Martin
If you want to push borrowing costs down even further, then you stop buying bonds and you start with the kind of safest stuff you can find in the market, which is government bonds. And if central banks buy enough of those bonds and they can push the price up, which pushes the yield down, and that quite quickly floods across financial systems, right? So if the borrowing rate for governments is much lower, it just helps to pull borrowing costs down for everybody. And that, again, in theory, should help them to get through difficult patches and should also push up inflation. But it has even more profound effects on the financial system as a whole. So people getting mortgages, people getting loans, companies issuing bonds, companies getting loans — it helps to control and pull down borrowing costs for all of those people.

Michela Tindera
OK, so the US Federal Reserve and other central banks did this around 2008 to encourage deals, encourage borrowing and to really just help everyone get through the financial crisis. So then why are we still talking about this now in 2022?

Katie Martin
You know, these programmes are all sort of starting to wind down. People are talking about, oh, you know, when can central banks step back from the bond markets? 2020 came along. The pandemic came along. Again, another gigantic crisis arrived.

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News clips
Concerns over the coronavirus outbreak. And once again, they are affecting the stock market . . . There’s a lot of unease and bad vibrations in the market. That’s the way it is . . . The Federal Reserve is taking sweeping action to try to protect the economy from the coronavirus.

Katie Martin
This time it didn’t kind of come from the core of the financial markets. It was a kind of big external shock. But it was very clear the policymakers had to do something dramatic to turn the ship around and that, those quantitative easing programmes that we saw just hit the steroids. And we saw, you know, the Fed didn’t just do QE, as we call it, it did unlimited purchases of US government bonds. It went into agency mortgage-backed securities. It launched facilities to buy corporate debt, municipal debt. It went all in. And over a two-year period, the Fed bought $3.3tn just in government bonds. So the size of the balance sheets and a lot of these central banks around the world has got enormous. So, you know, the Fed, we’re talking about $9tn, which is a chunk of change.

Michela Tindera
OK. So QE was a way to help with bringing up inflation. We obviously don’t need that anymore. So what happens now?

Katie Martin
And so it’s time for quantitative easing to go to bed and be replaced by quantitative tightening.

Michela Tindera
OK. So then tell me about QT. How’s it different?

Katie Martin
QT, quantitative tightening — try saying that with an egg in your mouth — is the opposite of QE and it basically means that central banks are shrinking their balance sheets and either stopping buying new debt or offloading debt that they already own. And this is a, this is a potentially pivotal moment. This is a really important process.

Michela Tindera
OK. And why is it so important?

Katie Martin
I guess the way to think about it is that the process whereby central banks pushed money into bond markets is reversing. So let’s look at what happened during that time when they were pushing the money in. Effectively, they were largely cornering markets in government bonds, which are the safest part of the bond market. And if they come in in size and, you know, snaffle up a large portion of the government bonds that are out there, then those bonds get really expensive and the yields on them get really low. And the whole point of QE is that if central banks corner the market in all the safe stuff, then private sector money gets forced out down the chain into other parts of the economy where it can be more useful and where it can, for example, help companies that otherwise might not make it. And it can just keep corporate bond markets alive in a time of stress. I mean, we certainly saw that in 2020.

Michela Tindera
So then what happens as we go the other way and move into QT?

Katie Martin
Logic dictates in a way that when that process starts reversing, then the opposite should be true. So one fund manager put it to me that, you know, the interest rate cuts really, really help economies, but they don’t necessarily help markets, whereas QE really helps markets but doesn’t necessarily help underlying economies. And so it sort of stands to reason that as QE reverses and flips into QT, as central banks start offloading these assets that they’ve been accumulating, that could have a destabilising effect on markets.

Michela Tindera
OK. So if there’s a chance of destabilising markets, why do the banks want to take this risk?

Katie Martin
It’s, you know, again, complete mouthful, total nightmare. But quantitative tightening is part of a tightening process, which goes hand-in-hand with raising interest rates. So it’s kind of a bit weird for central banks to give with one hand and take away with the other or to take away one hand and give with the other. So it’s kind of doesn’t make sense for them to be raising interest rates. And some of them are doing that unusually quickly now and to still be pumping money into the system. That doesn’t make sense. You’re kind of, you’re fighting with yourself. So this QT is part of a broader tightening in financial conditions. It’s part of this global tide of higher interest rates around the world.

Michela Tindera
So has this idea of QT been tried before? Is there any kind of precedent we can look to for guidance?

Katie Martin
There are precedents, but they’re generally in different economic conditions. And there’s no precedent for all of the, all of the big central banks doing this at more or less the same time. You know, we did see the Fed try and step back in 2017. They were like, oh, don’t worry, it’s going to be like watching paint dry. You’re going to find this a very boring process.

Michela Tindera
Mm-hmm. So how did that go then?

Katie Martin
Not great. Bad. (laughter) The Fed wanted to start chipping away at its balance, at its balance sheet. It wanted to do some QT. And it really did not go well. It really gave the markets a shock. They were like, oh, wait, you’re actually, you’re actually gonna do this. You’re gonna, you know, you’re gonna stop helping us. You know, what the hell is all this about? And there was, you know, there were some very shaky moments in markets there. And eventually markets shook violently enough that the Fed had to kind of back away and keep pumping in the support. And then 2020 came along.

Michela Tindera
OK. So that doesn’t sound so good. So what are your sources telling you now? How do they see things playing out this time?

Katie Martin
So I just kind of made a point of every time I was talking to a portfolio manager, every, every time I was talking to a chief investment officer at an investment firm, I would say, so, you know, this whole QT business, what do you think? How is it gonna work? And every single person said to me, yeah, I don’t know. I’ve got absolutely no idea. We don’t know if this is gonna be a complete train wreck. We don’t know if this is going to be absolutely fine. We don’t know if it will be somewhere in between. We don’t know whether if markets do freak out, central banks will, you know, change their minds and give us, you know, give us a bit more slack. They really have absolutely no idea how this is going to play out.

Michela Tindera
So what are they worried about? What do they think might happen?

Katie Martin
Among the investors that I speak to is just watch out for some kind of accident in the Treasuries market, in the US government bond market towards the end of this year, because that’s when QT is really gonna stop getting going in, you know, more, more forcefully. And you’ve got lots of macroeconomic forces that are pulling the market all over the place. Just don’t be surprised if this goes belly up at some point.

Michela Tindera
And what would that look like, this accident or going belly up? How would we know that that’s happening?

Katie Martin
Oh, you’d know. Probably because I’d be shouting about it. But the thing is, the US government bond market is not, is not any old market, it’s the world’s most important market. Everything is priced off of Treasuries prices. So whether it’s, whether it’s mortgages or whether it’s the value, the overall value of stock markets around the world, everything hinges on where Treasuries are trading. So if you start to see Treasuries’ prices move around really violently, that will send ripple effects throughout all of the major markets.

Michela Tindera
And what would that look like for regular non-investor people?

Katie Martin
If QT does contribute to the process whereby government bond prices are much lower and yields are much higher, then that is, at the very least on the margins, a contributing factor to how expensive it is for you or I or anybody else to borrow money, whether that’s for a mortgage or for a loan or on a credit card. Or whatever it is.

Michela Tindera
So now it’s been a couple of months since the Fed actually decided to officially implement QT. What’s been happening so far?

Katie Martin
At the moment, a lot of QT is around not buying new stuff. It’s not about selling existing stuff because they are two very different things that would . . . if they were selling particularly in large size into markets, then that really, that really could upset the apple cart. They’re not quite at that point yet, at least globally. So they are trying to be nice and boring. Central bankers love being boring. They want to be as boring as possible. That’s what they’re trying to do here. And we’re gonna have to see how successful they are.

Michela Tindera
OK. So that’s helpful to understand from a theoretical point of view, but how has this actually played out?

Katie Martin
So QE pumped a lot of money into the system effectively and crammed down bond yields. So if you get to the point where you’re earning nothing or indeed less than nothing on your government bonds, what’s the point in holding them? You go, you know, whether you’re an individual investor or a big pension fund, you know, it’s the same for everybody. You go further and further and further along this risk spectrum and you say, OK, well, I’m only getting kind of zero per cent of my government bonds and I’m only getting, you know, one point people were getting 2 per cent on their, on their corporate bonds, even for relatively risky companies. And, you know, so you just end up going, you end up putting money to work with riskier and riskier and riskier bets. And some of those bets have blown up in 2022. And that’s not necessarily all the fault of QT. You know, it’s partly the fault of rising interest rates. It’s partly the fault of just the state of the economy. But certainly, you know, what goes in must come out. This money that’s gone into the system has to bleed out at some point. And to the extent that it has supported risky assets over the past few years, logically, it does seem to make sense that a lot of support for those risky assets has now melted away. And so I guess what it means is that a lot of investments have just got to stand on their own two feet. You can’t expect them to be propped up by policymakers anymore.

Michela Tindera
So even though we seem to be stuck in this very uncertain time right now, when do you think we will know how this has all turned out?

Katie Martin
I suspect it’s gonna be a bit like, you know, the old adage about the French Revolution, you know, was-it-successful-it’s-too-early-to-tell kind of thing. I think it will be, it will take a long time for this to come out in the wash. And even when it does, so, for example, one of the big investment banks, I’m pretty sure it was Morgan Stanley, did a big report on previous efforts at quantitative tightening at different central banks. And they tried to kind of look at what the market did in response. And they were like, do you know what? It was a really mixed bag. Sometimes government bonds rose in price. Sometimes they fell in price. It was all very much contingent on what the underlying economy was doing, and there was a lot of very counterintuitive forces at play in the markets. And so there just isn’t, there isn’t a rule book for this. There isn’t a kind of manual that you can turn to and say right, now turn to page 25, quantitative tightening, this is what’s gonna happen. It doesn’t exist. And so that rule book will probably only end up getting written in five or ten years.

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Michela Tindera
So as quantitative tightening takes hold in the financial systems’ plumbing, it sounds like plenty of eyes will be watching closely for any issues that crop up. Let’s just hope we don’t have to call in the plumber.

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Behind the Money is hosted by me, Michela Tindera. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.

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