When it comes to reversing their crisis-era bond buying, central bankers are focused on the destination. Traders in risk assets care more about what could be a painful journey.
The contrasting views upset markets this week. Chairman Jerome Powell reiterated the notion that the Federal Reserve would remain on auto pilot when trimming its $4 trillion portfolio, and investors dumped equities in response.
The tension may prove even more consequential in 2019 now that the European Central Bank is stopping — though not yet unwinding — asset purchases. Bank of America Corp. analysts say liquidity from the developed world’s four major central banks will contract by $200 billion next year, driving volatility in the riskier markets that thrived under quantitative easing.
The liquidity drain is potentially destabilizing for risk markets because central banks are removing cash that was cheap to borrow and invest in high-yielding assets, including in emerging economies. Some analysts argue that so-called quantitative tightening is behind the recent selloff in equities and credit markets, overshadowing trade wars and a slowdown in global growth.
“The only thing that ties in the decline in global equities, the decline in EM over the summer is this global liquidity argument,” said Lee Ferridge, head of North America macro strategy at State Street Corp. Against this backdrop, he says short-maturity Treasuries are attractive, with high-yield credit looking particularly vulnerable.
For more on the perils of quantitative tightening
Views differ on exactly when the central-bank pullback will start to bite, or if it already has. Ferridge estimates the net drain on liquidity began in October, when the ECB halved monthly asset purchases to 15 billion euros ($17 billion), in preparation for stopping them this month. Also in October, after a year of shrinking its portfolio, the Fed raised the maximum monthly runoff to $50 billion — $30 billion for Treasuries and $20 billion for mortgage-backed securities.
Goldman Sachs Group Inc.’s Marty Young is among strategists doubting that quantitative tightening played a pivotal role in the recent market upheaval.
If the Fed’s runoff were such a dominant trigger, “we would expect to see the most extreme impacts on the agency MBS and Treasury bond sectors,” he said in a Dec. 21 research note. Instead, mortgages have performed in line with equities and Treasuries rallied, he wrote.
Benoit Coeure — a potential future ECB president — is among officials who’ve argued that central-bank policy and communications continue to support global markets. The Fed, the Bank of Japan and the ECB still have almost $15 trillion in their coffers from their fight to fend off deflation, meaning the financial system remains awash with money, and interest rates are still low. The BOJ continues to carry out quantitative easing.
But while central banks’ stock of high-quality assets may still be buoying the most liquid markets, Citigroup Inc. credit strategist Matt King argues that riskier, less actively traded markets are driven by the trajectory and not the level of assets.
As official buying turns to rolling off assets, “flow effects are likely to drive prices among risky assets in shallower markets including U.S. high-yield corporate bonds, Eurozone periphery bonds, Eurozone corporate bonds, global equities and EM assets,” King wrote in a report last month.
Powell this week restated the Fed’s preference to pare the balance sheet and use interest rates as the main tool for managing the economy. There was no sign he wants to adjust the pace of the withdrawal even if investors would like that.
“The runoff of the balance sheet has been smooth and has served its purpose, and I don’t see us changing that,” he said.
In an interview with CNBC on Friday, New York Fed President John Williams stressed policy flexibility, while holding to the view that the outlook for the economy remains bright.
“We did not make a decision to change the balance-sheet normalization right now, but as I said, we’re going to go into the new year with eyes wide open,” Williams said.
Adapting research from the Peterson Institute for International Economics, Yelena Shulyatyeva and Tim Mahedy of Bloomberg Economics reckon the Fed’s reduction of its portfolio next year will be equivalent to a quarter-point rate hike.
“Market expectations of a change at the December meeting were misplaced,” the economists wrote in a report. “The same will be true in 2019.”
Some market participants don’t share policy makers’ confidence that a gradual, telegraphed effort to shrink balance sheets will mitigate volatility.
“If the flow effect is negative, that is an important negative for markets even if it’s gradual,” said Gene Tannuzzo, deputy global head of fixed income for Columbia Threadneedle Investments. “It’s like the old phrase: Just because I tell you I’m going to punch you in the face, doesn’t mean it hurts less.”
Regardless of who’s right, recent market turbulence may be a sign of what’s to come.
The “market tensions we saw during this quarter were not an isolated event,” Claudio Borio, head of the monetary and economic department at the Bank for International Settlements, said in a speech this month. “Policy normalisation was bound to be challenging.”