The past year has seen an unprecedented monetary stimulus unleashed on the world – although it is not quite true that we have never been here before. In 1990, in response to the savings and loan crisis, Alan Greenspan cut rates, committed to keeping them low, and freely supplied funds to US banks. Such policies are common to today’s quantitative easing programs – although, as Andrew Hunt Economics notes, they were not called QE at the time. It was, perhaps, half QE.
The result was a familiar “melt-up”. Banks borrowed from the Federal Reserve at 3 per cent, and bought longer-dated Treasuries that yielded twice as much. Thus recapitalised, they created further liquidity, engendering a rapid financial recovery. Equity markets soared, bond yields dropped, and emerging markets boomed. Recovery in the real economy followed three years after.
So far so good. Then came the meltdown. Greenspan started to tighten in 1994. But because banks were so highly leveraged to government debt, this produced a bond market rout. The price of 10-year bonds collapsed, yields soared, liquidity was sucked out of the system and the recovery stalled. Emerging markets suffered particularly: Mexico’s Tequila Crisis followed in December.
Might history repeat itself? Israel, Australia and Norway have already raised interest rates; India, Brazil and South Korea are forecast to follow shortly. Markets are not predicting the US, UK or eurozone to raise rates while recovery remains so weak. Meanwhile, banks are loading up on government debt.
This is partly because they want to ride the yield curve, as in the past. But regulators also want them to hold more “high quality” liquid assets. Coincidentally, governments also need to fund their budget deficits. Indeed, to raise their bond holdings to historic levels, Credit Suisse estimates eurozone and UK banks have to buy another €600bn of government debt. The irony is that when rates do rise, the 1990s example suggests the subsequent bond sell-off could be huge, so re-creating the kind of problems policymakers are now trying to prevent.
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