The Return of QE

"With the exception of the Great Depression of the 1930s, the Great Inflation of the 1970s is generally viewed as the most dramatic failure of macroeconomic policy in the United States since the founding of the Federal Reserve."
Athanasios Orphanides, Professor, MIT Sloan School of Management

What went wrong last year?

According to one estimate (see here), households worldwide lost about $23Tn of wealth last year – mainly because of falling property and equity prices. That exceeds the losses suffered during the Global Financial Crisis (GFC). Losses back then were approximately $18Tn worldwide. I bring this up, as it shows how important liquidity has become in financial markets. The GFC did much more damage to the global economy than anything we endured in 2022, but liquidity last year was very tight.

The cost of capital (i.e. interest rates) is another way to think of liquidity and its importance to the wellbeing of financial markets. When interest rates were close to zero, plenty of borrowing took place for financial investment purposes, and that drove up risk asset prices. At the same time, households and corporates were reluctant to park excess capital with banks or in money market instruments, as the expected return was nil. Instead, they invested in risk assets.

Now, if you look back on the post-GFC era – an era I prefer to call the QE era – it is little wonder that household wealth grew so much during those years. Think about it. The cost of capital was non-existing. There was plenty of liquidity in the system thanks to central banks’ appetite for QE, and you couldn’t earn a dime on your capital, unless you were prepared to take some risk. And to cap it all – Wall Street were busy telling private investors that, as long as they followed a 60/40 investment strategy, they would never lose out, as equities and bonds are always negatively correlated (they said).

Reality turned out to be very different, though. The correlation between bond and equity returns, which had been negative for many years, suddenly turned positive (Exhibit 1), and all those ’wonderful’ 60/40 funds that investors had put their savings into began to deliver negative returns. And, to add insult to injury, for the first time ever, bonds losses were bigger than equity losses last year.