Top 3 ways to trade quantitative easing in 2020

What is quantitative easing?

Quantitative Easing (QE) – also referred to as ‘Large Scale Asset Purchases’ – is an unconventional monetary policy employed by central banks, focused on increasing a country’s money supply and ultimately driving economic growth.

Willem Buiter – CitiGroup's current Chief Economist – elaborates that QE aims to increase:

‘The size of the balance sheet of the central bank through an increase it is monetary liabilities (base money), holding constant the composition of its assets.’

How does quantitative easing work?

Fundamentally, Quantitative Easing is achieved by a central bank buying government securities: in most cases: buying long-term bonds. This is not always the case however, and in some instances a central bank may also purchase short-term bonds, asset-backed securities; such as mortgage bonds, and corporate paper.

In extreme cases: a central bank may even purchase equities, for example through Exchange Traded Funds (ETFs), as was the case with Japan’s QE attempts.

As with most things in the financial markets, the investment community remains divided on QE’s impact on other asset classes.

Some analysts argue that given its negative impact on cash returns, it potentially has the impact of pushing up the price of risk assets – such as equities. Others think it will cause stress to equity markets – given that the likely catalyst for QE itself would be a weakened economy. Others think that QE would hurt a country’s local currency – opening up opportunities for risk tolerate traders to go short or long the AUD, for example.

The Australian QE equation

Such division may increase in the first and second-half of 2020, with the prospect that the Reserve Bank of Australia (RBA) will implement its own version of Quantitative Easing potentially growing, as the official cash rate sits at historic lows and Australia’s growth outlook faces increased scrutiny. This debate was likely first sparked when the RBA’s Governor – Phillip Lowe – suggested that should the economic situation warrant it, Australia’s central bank itself may implement unconventional monetary policy, such as QE.

Looking at how an Australian-centric QE program would operate, Mr Lowe said it would focus on the purchasing of government bonds; bought on the secondary market.

This is an important distinction, the Governor points out, because:

‘In buying government bonds over other assets is that the risk-free interest rate affects all asset prices and interest rates in the economy.’

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To QE or Q-not

Vast market opportunities aside, though QE ideally aims to stimulate economic growth – this is not always the case. Mr Lowe appears aware of this fact, noting that, persistently low or negative interest rates invariably impact banks' net interest margins – which ultimately damages bank profitability and as a consequence, may potentially create less not more capacity to lend. Such an outcome would invariably curtail growth, not stimulate it.

Finally, and though a number of analysts, fund managers and market commentators have in recent times posited that the chance of QE has increased – Phillip Lowe has spoken firmly on this the matter – saying in November 2019 that:

‘The threshold for undertaking QE in Australia has not been reached, and I don't expect it to be reached in the near future.’

Even so, below we take a brief look at QE’s short but varied history and then examine a handful of expert views regarding how traders could potentially profit should the RBA pursue this unconventional monetary policy.

History of quantitative easing

Though the history of Quantitative Easing is a relatively short one, it nonetheless has provided central bankers with an idea of the potential impacts – both positive and negative – that QE can have on country’s economy, inflation levels and its stock market.

Japan: the birthplace of quantitative easing

Japan was one of the earliest adopters of QE – employing this unconventional monetary policy in March 2001. This first instance of QE – which saw Japan’s Central Bank increase its monetary base by ~60% – was mostly ineffectual, according to The Federal Reserve Bank of St. Louis (FRBS) – with inflation staying mostly the same during this period.

Targeting a 2% inflation rate, new QE efforts, spearheaded by Japan’s current Prime Minister Shinzo Abe since 2013 may prove more fortuitous. At the current stage, whether or not Japan’s latest foray into QE will prove successful remains to be seen, notes the FRBS.

The FRBS, surveying the recent data, noted that there has been an:

‘Uptick in the inflation rate since April 2013. But the evidence shows that the price level (CPI) can rise even in the absence of QE, so it's really too early to tell.’

The United States: a success story

Though Japan’s foray into ‘unconventional monetary’ policy left much to be desired – when the U.S. Fed implemented its own version of QE – in the wake of 2008’s Global Financial Crisis – it proved much more successful.

Here, the Fed expanded its balance sheet at a rapid rate – between 2009 and 2014 – buying ~$4.0tn in assets across bank debt, mortgage backed securities and treasury securities.

The Fed eventually ended its QE program in October 2014.

Speaking to the successful aspects of America’s QE program, Tyler Gallagher, head of Regal Assets, commented that thanks to the Fed’s aggressive large scale asset purchases:

‘Lethal subprime mortgages were removed from banks’ balance sheets, it has helped stabilize the U.S. economy — for the moment, and it has kept interest rates low enough to temporarily revive the housing market.’

Quantitative easing around the world

Regardless of the country, the impact of Quantitative Easing flows downstream: from central governments, to banks to people (the borrowers). The precise impact QE would have on this ‘flow’ in Australia however, remains up for debate and hard to predict.

Why should traders care about quantitative easing?

Centrally, traders, speculators and investors should care about Quantitative Easing due to the myriad of investment opportunities that it potentially opens up.

Understanding this, various analysts and money managers have in recent months began to more intensely discuss how Australian traders could potentially profit from QE. Juxtaposing this, such strategies also give insight into potential hedging strategies that investors could employ should the RBA pursue a QE program.

In saying that, there is no uniform consensus on the impact that an Australian-centric QE program could have on different asset classes. Even so, below we look at a few different trade opportunities that Quantitative Easing may create.

How to trade quantitative easing

Ultimately, how or even if investors trade a potential QE program will come down to personal preference. In saying that, equities, currencies and bonds may potentially be the most obvious options for investors looking to trade QE.

Equities volatile and yields drop

Jasmine Argyrou, a Portfolio Manager at Credit Suisse Private Banking Australia, in a recent Livewire markets video discussed the implications of QE – as well as the investment opportunities that it potentially opens up for Australian traders.

Mrs Argyrou notes that while Australia’s economy IS slowing – consumer spending remains resilient and equity market performance robust. Yet the risks are growing that Australia’s economic slowdown could deepen – in which case, she argues, it is likely that the RBA will embark on a QE program.

As a consequence of this, and a potential trade idea for active investors:

Mrs Argyrou argues that it is ‘probable or possible that there might be some equity market stress if the Australian economy takes a sharper turn down’ and ‘yields will probably fall.’

AUD drops, and equities run

Though Credit Suisse’s Jasmine Argyrou focused on the volatility that a QE program would create – Alexander Nakonechnyy – a Financial Adviser at Asparq, takes a more opportunistic view – especially as it applies to equity markets. Here, Mr Nakonechnyy noted that unconventional monetary policy:

‘Would depress returns from cash investments and potentially encourage investors into riskier assets.’

Not only that, but Mr Nakonechnyy further noted that:

‘Implementing QE measures would most likely put downward pressure on the Australian dollar, which can help support local exports.’

Bonds are the answer

Speaking to the AFR in late-2019, Westpac’s head of rates strategy – Damien McColough, proposed a simple trade idea: bonds. Here he noted that should the RBA implement QE:

‘We have preferred the 2027 maturity as it is cheap on an asset swap basis, relative to the bonds around it and, having left the 10-year futures basket, there are sufficient bonds outstanding for the Australian Officer of Financial Management to look elsewhere for future issuance.’

‘We think it is timely to have some exposure to a trade that would benefit to this approach, if indeed such a policy were to occur.’

Mr McColough noted that QE’s occurrence is not his firm’s ‘central case’.

Quantitative Easing summed up

Though there is no certainty that Australia’s Reserve Bank will pursue a program of Quantitative Easing in the near future – or even potentially ever – as we have shown today, there are a number of ways that traders and investors could potentially profit from it if the RBA were to pursue this unconventional ‘Monetary Policy.’

Stranger things, after all, have happened in financial markets in the past.

Where next?

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