The Reserve Bank of Australia (RBA) rates the chance of quantitative easing (QE) as low but the risks of our central bank being forced to use unconventional monetary tools to ward off an economic slowdown, or even a recession, is growing.
If this comes to pass, it would be a remarkable moment and it will have a significant impact on your share portfolio.
QE is regarded as the last line of defence that central banks have to fight a crisis and you can see why the RBA is reluctant to push this strategy as conditions aren't dire enough for radical action.
Why the RBA may be forced into QE
But as interest rates fall under 1% (as markets are predicting), rate cuts are becoming as effective as using a butter knife to loosen a bolt.
This is because banks can't pass on the full rate cut to borrowers when their profit margins are getting wafer thin. Banks are becoming a bottleneck just as they were during the GFC – the difference is that during the crisis, banks were too afraid to lend money, although the impact to the broader economy is the same.
The RBA knows it's close to reaching the effective limit of what rate cuts can do and it may need to dig deeper into its bag of tricks if our economy softens further from the global trade war.
What's Quantitative Easing?
When a central bank prints money to buy assets, that's QE. The goal is to inject a significant amount of new cash into the financial system to spur private sector investment and consumption.
The asset of choice for central banks is their respective government bonds – the ultimate risk-free investment on which all other investments are benchmarked. Buying these bonds will drive up prices and drive down yields as the two move in opposite directions.
If the 10-year government bond yield falls, it increases the appeal of other assets and that should (in theory at least) prompt investors to buy riskier assets.
But it isn't only sovereign bonds that the RBA can buy. The US Federal Reserve also snapped up mortgage-backed securities during the GFC because no one else dared to, while the European Central Bank bought corporate bonds to put cash directly into the hands of companies in the hope that they would increase capital expenditure and hire more people.
The Bank of Japan went a step further and bought Japanese equities. The performance of a share market is a big consumer sentiment driver.
How QE impacts on your shares
Even though that's a nice idea, the RBA is unlikely to go that far to step in to buy S&P/ASX 200 (Index:^AXJO) (ASX:XJO) stocks.
But they may not have to. Buying Australian government bonds is probably enough to keep our share market trading into new record highs as that will be more effective in driving down 10-year (and other long-dated) bond yields.
This is because interest rate cuts tend to be a big driver of bonds with nearer term bond yields but have limited impact on long-dated bonds – and stocks are valued using the 10-year yield as a reference.
Further, QE is better at supporting stocks because it doesn't hurt bank profits while cutting interest rates does.
But ultimately, perception could be as good as reality. Speculation that the RBA will start buying assets may be enough to keep the ASX on the front foot without our central bank pulling the QE trigger.
