Last night we reported that after pounding the table for the past month that contrary to what is now universal conventional wisdom (with a few exceptions, most notably BofA's Michael Hartnett who is warning of a recession in the second half as the "rate shock" morphs into a "recession shock"), this narrative has finally started to catch on with a growing number of banks starting to float the possibility of fewer rate hikes, whether due to the economic slowdown making itself apparent, or because of the growing Ukraine crisis which threatens the world with a sharp economic slowdown if energy prices soar (in a repeat of what happened in 2008).
Today, Bloomberg Markets Live commentator and reporter Simon White picks up on this theme, writing in an overnight note that central bank tightening is doomed to end prematurely, and explains why below.
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Projected rate hikes and expectations of the speed of central-bank balance-sheet contraction are ambitious and unlikely to be realized, with or without the threat of conflict between Russia and Ukraine. Yields look stretched and yield curves should soon face re-steepening pressure.
Inflation fears have prompted aggressive repricing of rates curves across the world. Despite some easing prompted by the escalation in tensions between Russia and Ukraine, the market still expects almost six 25bps hikes by the end of 2022 in the U.S. Even in Europe, where dovishness has ruled for many years, just under 40bps of rate hikes are expected by the end of this year.
But this is a very unusual rate hiking cycle. Rates have rarely been so low and central-bank balance sheets have never been so bloated. This creates a conundrum for central banks. Markets are more familiar with rate rises as a policy-tightening tool than balance-sheet contraction. The Fed -- still smarting from the memory of the Taper Tantrum in 2013 -- will raise rates while contracting its balance sheet. Other central banks will do likewise
This lets rate increases do some of the heavy lifting, and allows central banks to build a cushion should they need to ease policy again. But growth and liquidity conditions suggest they may barely get started before they are forced to stop again.
Take the Fed. It has a dual mandate -- inflation and employment -- but most market participants know it has an unofficial third mandate too: the market. The Fed hasn’t done any actual tightening, and other central banks have barely, if at all, got started, but global liquidity has already collapsed. That’s not good news for the market.
Excess liquidity -- the difference between real-money growth and economic growth -- tends to have the greatest impact on markets as it is the liquidity “left over” from the needs of the real economy and therefore available to boost asset markets. The fall in excess liquidity points to continued turbulence for equity markets.
The outlook for economic growth, too, is worsening. The NFIB Small Business Survey provides leading insights on the U.S. economy. Optimism is falling, which signals a slowdown in U.S. growth over the next year.
The level of implied tightening is already having an impact before central banks have materially tightened policy, making it more likely they will have to end their tightening cycles much faster than they or the market currently expect
In the U.S., implied tightening has been so extreme and front-loaded that conditions in the forward-yield space are more consistent with the end than the beginning of a rate-hiking cycle.
The Eurodollar curve between the sixth and 10th contracts (currently 2023/24 maturities) has already inverted. Normally this curve would hit its lowest point -- and remain un-inverted -- about one year after the Fed begins tightening.
As with the extent of anticipated rate hikes, projections for the pace of balance-sheet contraction are unlikely to be realized.
The FOMC, in the minutes released last week, implied that balance-sheet contraction will be faster than in the previous cycle. The $2.2 trillion of USTs (ex-Bills) maturing between now and 2024 will aid the Fed here, while limiting the need for active selling of Treasuries.
Nevertheless, contractions of the magnitudes being discussed have never been attempted. There is no guarantee the Fed, the ECB or any other central bank will be able to materially contract their balance sheets to the extent expected, especially when liquidity is collapsing and the outlook for economic growth is worsening.
BofA ML estimates a 20 percentage-point decline in GDP terms of the ECB’s balance sheet by the end of 2023. Wall Street estimates for Fed balance-sheet contraction are less aggressive, but still around 8-10 percentage points over approximately three years.
A 20 percentage-point peak-to-trough contraction in any central bank’s balance sheet would be unprecedented. Drawdowns of 8 to 10 percentage points have been seen before, but usually over a longer period than what is anticipated today.
Over the past 10 years, the largest balance-sheet contraction was the ECB’s in 2012-2014, of 11.4 percentage points. The SNB and the BoJ have seen similar declines, while the largest drop in the Fed’s balance sheet was about 8 percentage points between 2014 and 2019.
Balance-sheet contractions are bad for markets. In the post-crisis period (2015 to the present), equity markets have typically underperformed their long-run averages when central-bank balance sheets were shrinking.
These are not trivial matters. If they were, then there would be more examples of balance sheets returning to more “normal” levels.
The BoJ was the first to embark on QE as a “temporary” measure in 2001, yet its balance sheet has been on a one-way expansion trip for almost 15 years. Today the BoJ’s balance sheet is a dumbfounding 135% of GDP and still climbing.
The anticipated tightening currently seen is extreme, and already having a significant impact on liquidity and economic growth. Central banks are unlikely to get close to the level of rates currently priced or the anticipated reduction in the size of their balance sheets, before being forced to pause or reverse course by a worsening economic and market outlook.