QE is ending, so volatility is returning

Written by Michael McAlary

It has taken approximately 6 years for US Quantitative Easing (QE) to come to an end. Since the beginning of the Global Financial Crisis (GFC) many US mortgages have been re-financed, the clean out of defaulters has occurred and regulatory changes aimed at preventing poor lending practises while encouraging both private and Government Sponsored Enterprises (GSE), e.g. Freddie, investment have been implemented.

During this period there has been considerable commentary about the economic effects of QE in the form of currency wars and that cheap money has driven equity markets up. So what does the future hold? In the short term there will be a return to greater than normal price volatility particularly in debt capital markets, because QE has suppressed price volatility in these markets. The impacts of its end on other asset classes are now starting to be worked through the financial system. Equity markets are factoring in higher interest rates while currency markets notably the Australian dollar has significantly depreciated against the US dollar in recent days. These price corrections will continue as investors seek to price risk in a Federal Reserve intervention free world.

There may not be much agreement in Washington on most matters, but there is one item that the White House, Democrats, Republicans and regulators agree on – that in the future the US tax payers will never again bail out the mortgage industry. This is why the Tea Party and some sections of the Republican Party are trying to have Freddie and Fannie closed down, but what is more likely is that these organisations operating and risk frameworks will change. Initiatives such as Qualified Mortgages (QM) that defines the credit underwriting standards for a GSE securitisable mortgage and Qualified Residential Mortgage (QRM) that requires the originator and securitiser to carry first losses are being introduced. These compliance requirements are directed at preventing poor lending practices while establishing securitisable standards, so that investors understand and can have trust in the paper they are investing in while shifting the risk from the tax payer to private enterprise.

These “green shoots” appearing in the US secondary mortgage market reflect these regulatory initiatives and the forecast end of QE. This can be seen in the narrowing of the return expectation gap between the buy and sell side, because investors understand this asset class as it provides bond like returns without investing directly in bonds.