PART ONE – Monetary Policy: Quantitative Easing and the Race to the Bottom, Four Years On

Alexandra Gorewicz's picture

open pdf version“Be careful what you wish for, you may receive it.”

Over the last several months, it feels as if all central bankers have used every speaking opportunity to mention that their monetary policies, including bond purchases (quantitative easing or QE) and negative interest rates (NIRP), have reached their limits. This is an extremely important development, because it means that today’s monetary policies are no longer as effective as they once were. In other words, there is a non-zero probability that they will cease to work altogether. Wow. Tick tock.

In February 2016, we wrote that monetary policy had become a race to the bottom, so to us, this development was never a question of “if”, but  “when.” Today, nearly four years later, the European Central Bank (ECB) and Bank of Japan (BOJ) are, by their own admissions, scraping at the bottom of the barrel, but the problem is that they continue to scrape. As yields in these markets hover around 0%, European and Japanese investors are forced to continue buying higher-yielding assets abroad as their central banks crowd them out of their own markets. And by “abroad,” I am really referring to North America, the last bastion of (relatively) high-yielding securities among advanced economies. To us, yields of 1.8% and 1.5% on 10-year U.S. and Canadian government bonds appear very low after the significant fall in yields over the last 12 months (and last four decades!).

To German and Japanese investors, who receive yields of -0.35% and -0.2% on 10-year government bonds at home, North America is positive – and, therefore, high – yielding. This is why the world’s largest pension plan, the Japanese Government Pension Investment Fund (GPIF), recently announced its intentions to increase (yet again) its allocation to foreign bonds – an allocation that already stood at 18% of the portfolio at the end of June. This ensures the Japanification of advanced economies – low inflation plus low growth, leading to stimulus that pushes bond yield lowers – continues (see Figure 1). In fact, judging from bond yields, the Germans are even more Japanese than the Japanese.

Figure 1: Japanese Bond Yields vs. 10-Year Lag of U.S., Canada, U.K., and German Bond Yields

Japanese Bond Yields vs. 10-Year Lag of U.S., Canada, U.K., and German Bond Yields
Source: Bloomberg Finance L.P. December 1989 – December 2019 using daily yields.

When these flows into North America began in earnest nearly a decade ago, foreign investors (like GPIF) conservatively limited their purchases to AAA-rated bonds with less than 10 years to maturity, and generally focused on U.S. and Canadian government and agency mortgage-backed securities. As central banks were pulled further into the unconventional policy black hole, the yields on these bonds fell and foreign investors found that they had to take more risk to hit their return targets. First, they bought long-term (greater than 10 years to maturity) bonds. Next, they bought U.S. agency MBS with only implicit government guarantees (Fannie Mae and Freddie Mac) and other, non-AAA-rated provincial government bonds. By the third repetition, they began to buy investment-grade corporate and municipal government bonds. Now, many rounds later, they are buying collateralized loan obligations (CLOs) filled with loans made to lower-rated (riskier) and non-investment grade companies! After this latest round, the trend of GPIF buying riskier bonds as global yields fall has sounded alarm bells at the BoJ, whose October Financial Stability Report warned Japanese regional banks that they were loading up on securities that could make Japan’s financial system vulnerable to a change in credit conditions abroad. Huh, so let me see if I understand this correctly…the BoJ is now worried that investors are doing what it has been asking them to do for years (i.e. take more risk)? Talk about ironic. As the saying goes: “some people create their own storms, then get upset when it rains.”

“In order to attain the impossible, one must attempt the absurd.”

Despite its financial vulnerability warning, the BoJ is in no hurry to “normalize” monetary policy. It will continue to buy enormous amounts of stocks and bonds to keep its interest rates negative for as long as it takes to meet its inflation goal. Central banks, including the BoJ, typically aim to keep prices of goods and services growing at a steady rate. The target inflation rate is usually 2% – a level, interestingly, shared by all central banks across advanced economies, including the U.S., Canada, Japan, and Europe. Now I could write a whole blog to try to convince you (and myself!) of why 2% is the “right” inflation target, but a better question to ask is whether 2% is an achievable target for a group of countries with clear socioeconomic differences. The short answer is no, and in the absence of an explanatory blog on this topic, consider the following simple example. Canada’s population growth rate has been the highest among advanced economies for the past two years, while Japan will see its population contract by nearly 20% over the next 30 years. While both economies face tight labour markets today, Canada is addressing its labour shortage by importing more people who will work to build economic capacity today, and who will consume goods and services produced by that additional capacity tomorrow. Japan, on the other hand, is addressing its labour shortage by further robotizing its economy to build capacity today and will lose one in five consumers of that additional capacity tomorrow. As of November, core inflation in Canada and Japan stood at 1.9% and 0.5% year-over-year, respectively – the former close to the central bank’s 2% target, the latter, nowhere near it. Yes, this is a highly simplified explanation, but given the level of complexity that we have reached in our socioeconomic systems and capital markets, I try as often as possible to invoke Occam’s Razor: all things being equal, the simplest explanation is usually the best.

Now, if you are asking yourself why central banks are targeting 2% inflation, you can find a list of answers from central bank to central bank. When comparing those lists, there is a common (surprising) explanation: “because everyone else is targeting 2%.” For proof, I recommend reading through BoJ’s Deputy Governor Amamiya’s speech in August 2018. Now I know that does not inspire a lot of confidence, but it was not meant to. It was meant to soften the blow when you ask yourself an even scarier question: “do central banks, or anyone, know what causes sustained inflation?” Central bankers, such as the late Paul Volcker (U.S. Federal Reserve chair from the late 1970s to the late 1980s), have clearly demonstrated that they can kill inflation, when it occurs, by hiking interest rates. However, they have failed to convince us that they can revive it when it is nowhere to be found. They now, rightly, face a credibility problem: their extreme policies cannot generate inflation. And they cannot instill confidence in the market that inflation will rise over the medium-term (refer to Figure 2).  We know it and they know it.

Figure 2: U.S. inflation expectations over the next 10 years

Source: Federal Reserve Bank of Cleveland

Yet as today’s central banks desperately try to generate inflation, Volcker warned them (in his latest book, Keeping At It): “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically the “easy money,” striving for a “little inflation” as a means of forestalling deflation, could, in the end, be what brings it about.” Famous last words?

In my next blog, I will explain what this means for fixed-income investments in 2020.


Source: Signature Global Asset Management, Bloomberg Finance L.P.



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Published January 15, 2020


Submitted by Jim Durnin on

Hi Alexandra - Excellent article.. I look forward to the projections in your next blog. The sooner the better for 2020 unless you wish to tackle 2020 and 2021 projections. The 10 yr US Treasury is at 1.81% as I write this... Higher or Lower? ... Also consider in the coming months writing an article on 2% inflation and why as per your comment above "The target inflation rate is usually 2% – a level, interestingly, shared by all central banks across advanced economies, including the U.S., Canada, Japan, and Europe. Now I could write a whole blog to try to convince you (and myself!) of why 2% is the “right” inflation target" Thanks Jim

Alexandra Gorewicz's picture
Submitted by Alexandra Gorewicz on

Hi Jim,

Thank you for your comment/question! I will give the 2% inflation blog some serious thought, but I hope you saw that the PART TWO blog was posted. The last 2 weeks have been quite busy (as I’m sure you know that 10 yr U.S. Treasury is now closer to 1.5%.) From my seat, a lot has changed, and not changed in the last 2 weeks. What has changed? The coronavirus outbreak has spooked global markets so rates have fallen (government bond prices have risen) and stocks/risky assets have fallen. What has not changed? My own assessment of the fair value of 10y Treasury rates (between 1.7 to 2%) largely because 1) China and other DM nations have been quick to respond to the virus and appear to have a good grasp on the outbreak and 2) it is too soon to assess the economic impact to Chinese growth and, more broadly, global growth. Now fear can be a powerful driver of market returns; it can persist for a long time and trump fundamentals. So while I believe rates should drift higher, that may take a few months to materialize.


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