‘Quantitative Ceasing’: Reverse Quantitative Easing and its Effect on U.S. Corporate Credit Markets

Abstract

Since the U.S. Federal Reserve Bank has begun gradually unwinding its $4.5 trillion balance sheet, investors are anxious to see how credit markets will react to the end of U.S. quantitative easing and the dawn of tighter monetary policy. This paper tests if corporate credit markets are behaving differently now that the total stock of assets on the Federal Reserve’s balance sheet is declining; the research employs a sum of leastsquares time series regression that aims to measure the causal relationship between Federal Reserve assets and three different corporate credit spreads (investment grade, BBB and high yield) before and after the policy change. The results indicate that the basic correlation between Federal Reserve assets and corporate credit spreads is altered by the policy change. However, when controlling for other explanatory variables, the analysis shows that the causal relationship remains unchanged. This paper therefore concludes that there are stronger explanatory forces that are keeping corporate credit spreads low despite declining Federal Reserve assets. In the heat of the 2008-2009 Financial Crisis, the Federal Reserve Bank of the United States (Federal Reserve) purchased substantial quantities of government sponsored enterprise (GSE) debt, non-performing mortgage backed securities (MBS) and United States Treasury debt on the secondary market to provide stimulus to the U.S. economy and liquidity to its vital financial markets. The process, known by investors across the globe as “quantitative easing,” can be an effective monetary policy tool for central bankers to use when policy rates are already at or approaching zero. The policy has proven quite useful in the United States as all the major market indices are now well above precrisis highs, unemployment is the lowest it has been in two decades and the economy is growing at an impressive rate of 3.5% so far in 2018. Amidst the economic recovery, the Federal Reserve Bank announced in late October 2017 that it was planning to reduce the bank’s stock of reserve assets from $4.5 trillion to approximately $3 trillion by 2020. To avoid disrupting secondary markets, the Federal Reserve’s plan is to gradually allow the bonds and other securities on its balance sheet to come due without reinvesting the proceeds rather than flooding the secondary market with billions of dollars in securities all at once. As of September 2018, the Federal Reserve has successfully shed close to $200 billion in assets off its balance sheet. Since the Federal Reserve is now pivoting to a less aggressive monetary policy by allowing assets to mature without refinancing and hiking its trademark Federal Funds Rate which directly affects cost of overnight bank borrowing and indirectly affects institutional and retail lending – there are several essential questions that investors should be asking themselves: (1) How are the prices of riskier credit securities responding to the Federal Reserve’s policy change? (2) Are the prices of credit instruments reacting differently according to the risk associated with the underlying quality of debt? (3) If credit spreads are still decreasing despite the Federal Reserve’s transition to tighter monetary policies, what is causing them to do so? Since Figures 1, 2 and 3 show that corporate credit spreads are continuing to decline despite the Federal Reserve’s decision to raise rates and sell off assets, this paper hypothesizes that the inverse relationship between corporate credit spreads and Federal Reserve Assets has been disrupted and the two variables are now positively correlated. If true, it could imply that investors are not accounting for enough credit risk in the corporate debt markets and are therefore mispricing the securities that fall within each of the three sub-asset classes. The next section describes relevant research INTRODUCTION Economics, CCAS ‘19, jdeperrior1@gwu.edu