The great unwind. The challenge of withdrawing economic stimulus. Monthly Perspectives // Portfolio Advice & Investment Research.

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1 The great unwind Monthly Perspectives // Portfolio Advice & Investment Research The challenge of withdrawing economic stimulus April 2018

2 The great unwind // 2 What is normal? Sheldon Dong, CFA, Fixed Income Strategist Financial markets are still far from normal even after a decade removed from the Great Financial Crisis. Extraordinary measures put in place by central banks around the world to safeguard the financial system, restore economic confidence and growth are still with us today, although they are slowly being removed a process called normalization. Examples of what are still not normal include: 1) negative-yielding government bonds in Europe and Japan; 2) the Bank of Japan (BoJ) targeting a yield of 0% for its 10-year government bond and buying unlimited quantities of that bond should the yield drift much above target; and 3) the European Central Bank (ECB) and the BoJ still engaging in large-scale purchases of financial assets through programs called quantitative easing (QE) to help keep interest rates extraordinarily low and support financial asset prices. The asset purchases are mainly government bonds, but the ECB also buys corporate bonds, while the BoJ has a wider scope through the purchase of Japanese equities through exchange-traded funds (ETFs). The cumulative purchases by the BoJ of Japanese equities are becoming substantial, with the central bank projected to own 10% of the market sometime between , depending on the interim market performance and without adjusting the pace of ETF purchases. While the unprecedented prescriptions made by central banks have proven to be largely successful, there are also side-effects, such as the suppression of volatility in financial markets. The U.S. Federal Reserve (Fed) started to normalize its balance sheet in October 2017, pledging to be careful and gradual, but the simple truth is that the Fed and other major central banks have no experience in returning interest rates to more normal levels while shrinking their portfolio of assets purchased through QE. Table 1: Volatility of Canadian Government Benchmark Bonds Table illustrates the expected change in price and yield of Government Benchmark Bonds if interest rates rise and fall by indicated amounts bps -50 bps March 16, bps +100 bps 2-year 0.76% 1.26% 1.76% 2.26% 2.76% 1.25% February 1, 2020 $ $99.98 $99.07 $98.16 $ year 0.98% 1.48% 1.98% 2.48% 2.98% 1.75% March 1, 2023 $ $ $98.94 $96.62 $ year 1.14% 1.64% 2.14% 2.64% 3.14% 1.00% June 1, 2027 $98.78 $94.55 $90.55 $86.68 $ year 1.29% 1.79% 2.29% 2.79% 3.29% 2.75% December 1, 2048 $ $ $ $99.18 $89.61 Source: Bloomberg Finance L.P. Portfolio Advice & Investment Research. As at March 16, 2018.

3 The great unwind // 3 The great unwind During the Great Financial Crisis, the Fed found the traditional tools for monetary policy insufficient to stimulate the economy. From December 2008 to December 2015, the Fed s primary policy tool, the target Federal funds rate, was set at a terminal floor between 0% and 0.25%, as there was an explicit commitment not to experiment moving the rate into negative territory due the damage low rates had done to the money market industry. With standard monetary policy insufficient amid signs of extended economic weakness, the Fed took to unconventional policy through large-scale asset purchases, or quantitative easing (QE). The very first implementation of QE took place in November 2008 (QE1), followed by additional rounds in 2010 (QE2) and 2012 (QE3), each slightly different. As the Fed bought securities (U.S. Treasury bonds and agency mortgaged-backed securities) from private investors, it increased the demand for these instruments, driving down the yields. It was also an overt signal to keep rates low, reinforced by a significant event between QE2 and QE3 with the Fed s decision to apply Operation Twist in September Operation Twist is quantitative easing in which the Fed sold its short-term Treasury Bills, and used the funds to buy long-term Treasury notes to help drive down longer term interest rates. This was important for the U.S. housing market recovery, as its most-common mortgage the 30-year fixed rate is priced off of long term U.S. government bond yields. The Fed s QE program ended in October 2014, but it reinvested the maturing securities from the portfolio through September The Fed owned $1.77 trillion of agency mortgagebacked securities (MBS; nearly 29% of all outstanding) and $2.46 trillion of U.S. Treasury securities (more than domestic pension funds, banks, and insurance companies combined) in late September 2017 and began to reduce the amount of these portfolio holdings in October The Fed has been transparent about the course of the unwinding process in the hopes of not disrupting financial markets. As the Fed s $4.4 trillion balance sheet portfolio declines, the effects of the QE process should reverse. The Fed will demand fewer securities, requiring other investors to absorb these securities, theoretically requiring higher yields. An analysis by TD Economics suggests that QE pushed down the longterm yield on U.S. Treasuries by approximately 30 basis points (bps) and the average MBS yield spread was lowered by an additional 40 bps. As well, bond market volatility is expected to normalize with the Fed no longer providing suppression as a large price-insensitive buyer. Figure 1: Government of Canada Long Bond Yield* 20% 18% 16% S 14% 12% 10% 8% 6% 4% 2% 0% *Modified : +10-year Average Used for Early History. Source: TD Wealth; Bank of Canada, Bloomberg Finance L.P. As at March 16, 2018.

4 The great unwind // 4 Former Federal Reserve Chair Janet Yellen said in her speech titled A Challenging Decade and a Question for the Future, on October 20, 2017 that The FOMC (Federal Open Market Committee) does not have any experience in calibrating the pace and composition of asset redemptions and sales to actual and prospective economic conditions. Indeed, as the so-called taper tantrum of 2013 illustrated, even talk of prospective changes in our securities holdings can elicit unexpected abrupt changes in financial conditions. Given the lack of experience with reducing our asset holdings to scale back monetary policy accommodation and the need to carefully calibrate the removal of accommodation, the FOMC opted to allow changes in the Federal Reserve s securities holdings to play a secondary role in the Committee s normalization strategy. Rather than balance sheet shrinkage, the FOMC decided that its primary tool for scaling back monetary policy accommodation would be influencing shortterm interest rates. Globally, the BoJ and the ECB are still engaged in QE heavily influencing assets values and market volatility. As recently as March 13, 2018, both The Wall Street Journal and Bloomberg reported that not a single Japanese benchmark 10-year bond traded on an exchange that day, citing data from Japan Trading Co. Not only has the BoJ set a target of zero percent for the bond s yield, its purchases of that issue had risen to 432 trillion, or about 44% of the market, to suppress volatility. BoJ Governor Haruhiko Kuroda noted to lawmakers on March 14, 2018 that the central bank had bought 75% of the government bonds issued in the fiscal year ending March The early February spike in equity market volatility came on the heels of rising longer-term yields (since mid-december) and bond market volatility. In early January, bond market volatility as measured by realized volatility in the U.S. 10-year Treasury note, had fallen to a 52-year low, according to a report from Bank of America Merrill Lynch. Ultimately, these long periods of muted moves lead to a mean reversion, and it did just that, spiking up in reaction to the new U.S. tax reform and a fresh spending program amid an already-strong American economy. Perception of interest rate risk increases The jump in volatility represented a change in perception towards greater inflation and interest rate risk, as well as a higher term premium related to the additional Treasury supply that will be required at a time when the Fed is unwinding QE. This upsets the supply/demand balance of Treasury bonds and portends higher rates. TD Economics forecast the U.S. Treasury will issue close to US $1 trillion this year and even more in 2019, nearly double the net debt issuance from However, neither the steady rise of government rates nor the recent equity sell-off coincided with wider corporate credit spreads, which remain near record lows and suggests the recent market volatility was Fed induced. For stocks markets, the jump in market volatility in February was simply in reaction to bond market volatility. Even in less unprecedented times, tighter monetary policy has led to higher volatility in equity markets. Figure 2: Bond and Stock Market Volatility September 1, 2017 Merrill Lynch Options Volatility (bond volatility) (RHS) CBOE Volatility Index (VIX) (equity volatility) (LHS) November 1, 2017 January 1, 2018 March 1, Source: Bloomberg Finance L.P. As at March 13, 2018.

5 The great unwind // 5 More bond market volatility The road towards normalization of central bank policies has been well communicated to be gradual in order to minimize volatility in financial markets. However, the process of moving interest rates higher at the same time as unwinding asset purchases is unprecedented. Sharp movements in interest rates reflect an increase in market volatility, something that bond investors have not experienced in some time. Rising interest rates reduces the market price of a bond, as existing securities become less attractive compared to newer issues with higher yields. This adjustment process is called interest rate (or market) risk, whereby the price of existing bonds are repriced so that their yield becomes equivalent to what is current. Bond investors have only experienced the positive side of interest rate risk, as yields have been in a secular decline since the 1990s. But every once in a while, there are cyclical increases in yields such as the one we have been experiencing since the summer of If the rise in rates is gradual, bond investors may not notice, as the decline in market value is offset by the income earned on the bond. Market risk becomes apparent to most when there are sharp movements in interest rates. Bond investors need not worry about market risk if they own individual securities and plan to hold them to maturity. In that case, a bond provides precise cash flows to an investor. If investors need to sell their bond investments before maturity, they can lower their market risk (price sensitivity) by reducing the maturity and increasing the income stream (coupon) of their securities. While rising interest rates may lower the market value of bond investments, they also provide opportunity for fixed income investors, as over time they can reinvest proceeds from maturing bonds in new bonds at higher interest rates. For longer term fixed income investors, a return to higher, more normal, levels of interest rates is something that should be welcomed. Bond investors need to get accustomed to more normal market volatility. Figure 3: Bond yields still not normal % Germany Japan Zero yield line Yields in Gemany negative up to approx. 5 years Yields in Japan negative up to approx. 10 years 3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 15Y 20Y 30Y Source: Bloomberg Finance L.P. As at March 21, 2018.

6 Market review The great unwind // 6 (%) (%) (%) (%) (%) (%) (%) (%) (%) Canadian Indices ($CA) Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs S&P/TSX Composite (TR) 51, S&P/TSX Composite (PR) 15, S&P/TSX 60 (TR) 2, S&P/TSX SmallCap (TR) U.S. Indices ($US) Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs S&P 500 (TR) 5, S&P 500 (PR) 2, Dow Jones Industrial (PR) 24, NASDAQ Composite (PR) 7, Russell 2000 (TR) 7, U.S. Indices ($CA) Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs S&P 500 (TR) 6, S&P 500 (PR) 3, Dow Jones Industrial (PR) 31, NASDAQ Composite (PR) 9, Russell 2000 (TR) 9, MSCI Indices ($US) Total Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs World 8, EAFE (Europe, Australasia, Far East) 8, EM (Emerging Markets) 2, MSCI Indices ($CA) Total Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs World 10, EAFE (Europe, Australasia, Far East) 10, EM (Emerging Markets) 3, Currency Level 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs Canadian Dollar ($US/$CA) Regional Indices (Native Currency) Price Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs London FTSE 100 (UK) 7, Hang Seng (Hong Kong) 30, Nikkei 225 (Japan) 21, Benchmark Bond Yields 3 Month 5 Yr 10 Yr 30 Yr Government of Canada Yields U.S. Treasury Yields Canadian Bond Indices ($CA) Total Return Index 1 Month 3 Months YTD 1 Yr 3 Yrs 5 Yrs 10 Yrs FTSE TMX Canada Universe Bond Index 1, FTSE TMX Canadian Short Term Bond Index (1-5 Yrs) FTSE TMX Canadian Mid Term Bond Index (5-10 Yrs) 1, FTSE TMX Long Term Bond Index (10+ Yrs) 1, Sources: TD Securities Inc., Bloomberg Finance L.P. TR: total return, PR: price return. As at March 29, 2018.

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