IT’S the moment of reckoning that many investors have been dreading, amid predictions of fresh market turbulence and even a bond market meltdown.
When the US Federal Reserve meets later this month, it is expected to signal the end of quantitative easing (QE) after five years of using it to prop up the economy.
And while talk of tapering off QE reflects growing confidence in the economic recovery, the ripple effect created could spark fresh volatility in bond markets in particular.
The effect of QE – in which central banks “print” money to buy bonds – has been to drive down interest rates, reduce volatility and encourage investors to increase their exposure to risky assets.
Now the US Federal Reserve is preparing to pare down the monthly bond purchases it makes through the programme, although there remains a chance that events in Syria and the looming debt ceiling could delay the move.
So should we be braced for a rocky ride if the Fed decides to act, or do investors have nothing to worry about?
Experts are divided on exactly how ordinary investors will be affected – some say bond investors especially could face a liquidity crunch that could leave some unable to take their money out of certain bond funds.
Others are more optimistic. They include James Budden, marketing director at Edinburgh investment house Baillie Gifford, who believes tapering points to a “robust recovery”.
“The medicine is being reduced as the patient recovers, yet the markets behave as if collapse is likely if the stimulant is withdrawn. Time will tell,” he said.
As John Bell, Edinburgh-based chartered financial planner at Carbon Financial Partners, pointed out, QE is a fiscal stimulant with unwanted side-effects, not least the erosion of pension incomes.
“By and large, the tapering off of QE is good news and a sign that the global economy is on the mend. As QE artificially boosted the value of government bonds [gilts], investors have been fearful of the reverse as QE is removed.”
Equity investors have little to fear, according to Bell. “Markets are forward-looking and have already priced in all known information. Profiting from market reaction to any surprise changes to QE policy involves knowing future events before they have happened.”
Some investors have already acted in anticipation of a QE slow down, backing away from riskier assets such as emerging markets in recent months.
“What we’re seeing in the emerging markets, and Asia in particular, is a manifestation of QE, as investors try to work out what assets have been pushed up most by the printing presses and withdraw their investments,” explained Haigh Bathgate, chief investment officer at Turcan Connell.
That’s why he cautions against piling money into those regions right now, referring to such a gambit as like “trying to catch a falling knife”.
But it’s bond investors that need to be most vigilant as the US looks to slow down QE. That’s because the process will eventually push interest rates up, eroding fixed-income values.
There’s also the matter of getting the timing right in withdrawing QE – get it wrong and there could be significant turbulence in the gilts market in particular, Bathgate warned.
“Put simply, the return in terms of income yield that you can get from a government bond does not compensate you for the potential risks.”
Even if the government continues paying the interest on gilts, investors could still suffer big capital losses, said Bathgate. And when that happens some may find that liquidity has dried up in corporate bonds especially as investment banks move away from the market.
“This means that, if we see a significant and sustained sell-off in corporate bonds, there is very little liquidity available to buy the bonds which is likely to result in even more erratic price moves,” said Bathgate.
It is “entirely conceivable” that certain open-ended bond funds may need to consider locking investors in if there’s a rush to withdraw holdings, he said.
The key for ordinary investors is to spread their cash across different assets and ensure they’re not too exposed to any one market, including fixed-income.
Bell said: “For those unable to predict the future, risk can be reduced by diversifying and not holding the vast majority of savings in UK Government bonds, particularly longer-dated bonds which are more sensitive to changes in QE policy.”