News analysis

Will end of cheap credit spell end of bull market?

A police officer keeps watch in front of the US Federal Reserve in Washington. PHOTO: REUTERS

When the United States central bank unleashed a flood of liquidity in early 2009 to extinguish the financial firestorm raging in the global economy, there were considerable misgivings over whether this would spawn a host of fresh problems.

Sure, the objective of quantitative easing (QE) - as the move by the Federal Reserve to expand the money supply by funding debt issued by the US government is called - was to deluge the financial system with so much money that it would drive down long-term interest rates, push investors into riskier assets and spur investments in a then crisis-hit economy.

But the fear was that taken to excessive levels, this could lead to hyper-inflation - like that observed in Germany in the 1920s - with prices of essential goods spinning out of control as paper money became worthless.

Happily, this gloomy scenario did not pan out, even though the Fed's printing presses went into overdrive.

It eventually expanded its balance sheet to a prodigious US$4.5 trillion in three QE programmes between 2009 and 2014, yet global inflation has remained subdued and the US dollar has largely retained its store of value against other currencies, such as the euro and Singapore dollar.

Indeed, the US ploy was so successful that it was later adopted by the European Central Bank and the Bank of Japan, which both started QE programmes to try to reinvigorate moribund economies.

Now, the Fed has taken a historic decision to begin paring the size of its balance sheet next month. Instead of reinvesting all the money it receives when the bonds mature, it will only reinvest part of the funds, gradually increasing the amount redeemed and not reinvested.

As the move had been carefully flagged in recent months, it has not roiled financial markets in a big way. The US stock market has taken the anticipated tightening in its stride, with the widely watched S&P 500 closing 0.1 per cent up at another record high on Wednesday after the announcement was made.

Emerging markets, which were rocked by the so-called "taper tantrums" in 2013, when the Fed said it was looking at slowing the pace of bond buying in its third QE programme, also largely shrugged off the move. The Straits Times Index eased a mere 4.2 points, or 0.13 per cent, to 3,213.8 yesterday.

Still, despite the lack of a market reaction, some experts are worried whether the "great central bank unwind" may inadvertently sow the seeds for the next financial crisis.

One concern is whether the world has become so used to cheap credit that the Fed's scaling back of liquidity may derail the fragile global economic recovery taking place.

This worry is reflected by Mr Claudio Borio, the chief economist at Bank of International Settlements, the bank for central banks. He was quoted in Britain's Financial Times as saying that the easing by central banks had caused bond and equity prices to rise beyond their fundamental value.

The risk is that companies may face a debt trap because they had borrowed so much money when credit was cheap and may struggle to repay as interest rates go up with the Fed's tightening, he added.

Another concern is whether central banks can really undo the stimulus without creating headwinds in financial markets, given that rock-bottom interest rates have prompted investors hungry for high returns to pile into stocks and other risky assets.

That, in turn, helped fuel a gigantic bull run which has enabled Wall Street's S&P 500 to soar 270 per cent and the STI here to gain 82 per cent since 2009.

Doomsayers recall that during the Great Depression era in the 1930s, when the Fed started to drain excess liquidity from the banking system, the move caused the US market to plunge and the economy to dive.

But this important history lesson is one reason the Fed is proceeding so cautiously with the shrinkage of its balance sheet.

Yes, there is cause for concern over the impact its tightening move will have on the global economy.

But worries over the Fed's flood of liquidity triggering hyper-inflation had turned out to be unfounded. Similarly, the gradual tightening may turn out to be every bit of a non-event as much.

No wonder, financial markets are not reacting.

A version of this article appeared in the print edition of The Straits Times on September 22, 2017, with the headline 'Will end of cheap credit spell end of bull market?'. Subscribe