Central banks’ QE distorts bond market

Since the financial crisis of 2008, central banks have resorted to asset purchase also known as quantitative easing (QE). Despite the beneficial effects some concerns remain over the long term -

• Quantitative easing (QE) has been distorting the liquidity of the bond market, the fall out in the absence of the usual agents like investment banks who have reduced their portfolio inventory significantly in the wake of tougher regulations namely Dodd Frank.

• QE & extending the maturities have also affected the term premium, in turn affecting the long term inflation expectation.

• It has also distorted the country risk premium associated with the yields.

Results -

• The reduction in volatility across asset classes have endorsed excessive risk taking.

• Reduction in bond yields, have encouraged entities to hunt for yield in other markets ike to hunt for repos through commodity market.

• Recent movements of portfolio money suggest investors are getting hooked to QE.

Caution -

• As the central banks will start winding up or concluding the purchase like Federal Reserve is doing recently, at some point of time the fall out in bond yields could be severe.

• At one point, though this looks a distant future, market will find the risk premium received over volatility & countries are not sufficient which in turn would blow out much faster.

Though volatility across treasuries, stocks, indices remain depressed but rising steadily. It is not advisable to bet excessive on the low volatility especially in the corporate and junk bond market.