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What Happens When the Quantitative Easing Program Ends?

The Quantitative Easing Program Is Over. Now What?

Have six full years really passed since the financial crisis of 2008?

Former Federal Reserve Chairman Ben Bernanke has declared it the worst financial crisis in history, surpassing even the Great Depression. Yet it’s time to acknowledge that we’ve weathered most of that storm and its aftershocks—thanks at least in part to the unconventional asset-buying policy known as quantitative easing, or QE for short.

The idea behind QE was to have the Fed jump-start the economy via a steady purchase of long-term Treasuries and mortgage-backed securities. By increasing liquidity within the financial system, quantitative easing was meant to encourage banks to lend money and stimulate growth during a time of great uncertainty and volatility.

The program was controversial from the start, and its effects will be debated for years to come. But now that it’s over, many investors are wondering what happens next. To understand the implications of the post-QE era, it’s useful to take a look at where it all began and where we’re headed in 2015 and beyond.

The quantitative easing program used creative measures in desperate times

When the financial crisis hit in 2008, the collapse of the financial system seemed imminent. And it soon became obvious to the Fed that conventional efforts to stabilize and reignite the faltering economy were woefully inadequate. So the Fed began issuing digital money of sorts to buy long-term Treasuries, mortgage-backed securities and other assets from banks.

Flush with cash from the Fed, banks now had an incentive to lend more to consumers and businesses. The idea was that increased lending would revive economic activity and ultimately boost consumption and investment, create jobs and help the economy recover.

The strategy worked—in part. While the Fed was buying bonds, interest rates fell due to the zero short-term rate policy and lack of demand. Thus, some consumers were able to obtain cheaper mortgages—helping the real estate market recover—and businesses had the capital to increase investments. The problem: Banks hoarded much of the cash in the form of reserves, while corporations kept a lot of cash on their books instead of hiring more workers.

It’s time to lose the security blanket

The Federal Reserve started scaling back on its asset-buying last January, and ended the quantitative easing program in October. The lengthy effort has caused the Federal Reserve’s balance sheet (which includes Treasury bonds, agency mortgage-backed securities, liquidity to credit markets and lending to financial institutions) to swell from just under $1 trillion in 2007 to more than $4.4 trillion, or around 25% of gross domestic product (unadjusted for inflation). That’s only the second time in history it has reached those proportions.

The big question now: What happens when the Fed divests its massive holdings of bonds and other securities into the financial markets?

The size of the Fed’s balance sheet may not be as troublesome as some investors believe, according to an analysis by Kathy Jones, fixed income strategist at the Schwab Center for Financial Research. The Fed had a similar-sized balance sheet—as a percentage of nominal GDP —during the Great Depression and again during World War II, which it managed to successfully unwind in the following years without damaging the economy.

But the other concern is that the end of QE could signal a sudden rise in inflation and interest rates as the economy recovers. “We aren’t likely to see anything quite so dramatic, despite predictions to the contrary,” says Kathy. “It’s more likely that inflation will remain modest and interest rates will slowly tick up over time.”

The reason is that banks are keeping most of the cash they received from quantitative easing at the Federal Reserve and out of circulation, which has limited inflationary pressures, she explains. “And the central bank is likely to hold most of its securities to maturity rather than trying to unwind a large portion of its balance sheet by selling the securities before they mature.”

What Happens When the Quantitative Easing Program Ends?

Although volatility might pick up as the Fed exits quantitative easing, it isn’t a foregone conclusion that interest rates will spike higher. If inflation were to become a problem, the Fed could begin winding down its balance sheet or take other measures to keep cash out of circulation, such as paying interest on reserves to encourage banks to hold them rather than lend them. The quantitative easing programs in Japan and Europe could also increase demand for Treasury securities as a more attractive alternative to low-yielding sovereign bonds, keeping interest-rate growth in the U.S. relatively subdued.

Talk to a Fixed Income Specialist at 877-566-7982.  FIND A BRANCH

Plan for the transition

So what does this mean for you, going forward? Transitioning to short-term bonds right now in anticipation of rising interest rates may be premature, Kathy says. “We suggest investors should focus on mostly medium-term bonds for now. When 10-year Treasury yields reach the key 3% level once again, then it may be time to transition to more long-term bonds.”

While many of the concerns over the unwinding of QE have been overblown, “it’s inevitable that our current, artificially low interest rates will eventually rise,” she says. “The smart strategy is to manage bond durations so that you aren’t too exposed to the risks of rising rates in your fixed income portfolio.”

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors. For further details, please contact a Schwab fixed income specialist.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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