Last week, when we quantified what China's reserve unwind [11], aka Treasury liquidation, could mean in practical terms, we quoted Bank of America which put the total Reverse QE figure as we dubbed it (or Quantitative Tightening in DB's terms), at between $1 trillion and $1.1 trillion.
At the same time, Deutsche Bank added fuel to the fire, when it noted [12]that "the potential for more China outflows is huge: set against 3.6trio of reserves (recorded as an “asset” in the international investment position data), China has around 2trillion of “non-sticky” liabilities including speculative carry trades, debt and equity inflows, deposits by and loans from foreigners that could be a source of outflows (chart 2). The bottom line is that markets may fear that QT has much more to go."
Deutsche was kind enough to provide a silver lining to this otherwise dreary forecast: "What could turn sentiment more positive? The first is other central banks coming in to fill the gap that the PBoC is leaving. China’s QT would need to be replaced by higher QE elsewhere, with the ECB and BoJ being the most notable candidates."
And there it is: the only thing that can offset the synthetic inverse QE that China and/or the rest of the EMs embarked on as Zero Hedge first warned last November [13], is more quite tangible QE conducted elsewhere, ideally at the ECB (which is currently 6 months into its first QE episode), or Japan (although the ceiling to debt monetization there may have been already hit with the BOJ already monetizing more than 100% of all gross issuance) but not the Fed, whose rate hike intentions are what started this entire global reserve liquidation fiasco in the first place.
Fast forward to today, when just two days before the September 3 ECB governing council meeting and press conference, ABN Amro released the genie from the bottle, when its head macro strategist Nick Kounis said the he now sees [14]"a much bigger risk that the ECB will step up QE as soon as this week’s meeting. We see this probability at around 40%, so it is an increasingly close call. The renewed drop in oil prices, which will keep headline inflation lower for longer is a key factor behind the rising risk of action in our view. This has also led to a sharp fall in inflation expectations, as measured by the 5y5y inflation swap, that ECB President Draghi has put a lot of weight on in the past (see chart)."
Why only 40%?
Our base case of no further QE ( now with a 60% chance) is still supported by indications that a moderate economic recovery is continuing, and by the bottoming out of core inflation. In any case, we expect Mr. Draghi to step his dovish rhetoric at this week’s meeting.
However, not even Kounis is so bold as to suggest that the Fed will scrap its rate hike strategy and proceed straight to more QE:
we have changed our forecast of the timing of the first rate hike by the Fed to December from September previously. There is still a chance of a move next month, given the ongoing strength in the economy and the labour market. However, we think that the FOMC will take a cautious approach given the ongoing fragility of financial markets (for instance, the VIX is still above its long-run average level). Officials may therefore decide that it makes sense to wait and see rather than risk rocking the boat. In addition, by December, the Fed will also have a better insight into how China and the global economy in general are developing. With inflation subdued it may well judge it can afford to take its time. So overall, we now expect one hike in Fed’s target for the fed funds rate this year, compared to two previously. We continue to expect four rate hikes next year, meaning a one-every other- meeting pace.
What does this mean for asset prices? Well, not much apparently with forecasts for US and German TSYs largely unchanged:
We now expect 10y Bund yields to remain broadly flat over the next few months, with an end of year forecast of 0.7%. Although the economic recovery should gain some pace, ongoing speculation about further ECB monetary easing should keep yields anchored. We still expect yields to rise next year (to 1.6% by end-2016). Meanwhile, we still expect 10y Treasury to rise this year and next, but the rise is likely to be more moderate than before – especially in the next few months - given less Fed hikes. We see yields rising to 2.4% by year end and 2.8% by the end of next year.
Perhaps ABN's boldest call is on the EUR, which the Dutch bank sees at parity by year end.
All of this is reasonable, and the only fly in the ointment would be if the Fed does indeed take a hard right turn sometime in the next 3 weeks and decided that not only is a rate hike now impossible (and with the global and US economy rapidly stalling, would unleash the ghost of 1937 all over again as we previewed before) and would be in fact destructive to not only the economy but also confidence as measured by the S&P, but potentially pull a Bullard, and hint that should the market drop not stabilize, the Fed is ready to use "unconventional tools", even if one considers that over the past 7 years, QE has become the most conventional - and only - tool left in the Fed's arsenal.
Finally, while we agree with ABN that the ECB may indeed boost QE in a rerun of what the BOJ did in the great Halloween massacre of 2014, it would be largely a non-event, as the ECB biggest limitation remains the availability of monetizable assets. As such, any real monetary offset to the Reverse QE that is about to be unleashed now that the "Great Accumulation" is over [15], is and will always be the Fed. For a quick explanation of this, re-read "Why QE4 Is Inevitable. [12]"
