While central banks’ grip on the economy seems to be waning, notes Citi's Matt King, additional liquidity still seems as potent as ever when it comes to propping up global markets. The question in our minds revolves around whether central banks remain willing to keep pumping when the economic benefits are so questionable. Equally, though, valuations are already so elevated that we doubt they can afford to stop. One way or another, this feels like a recipe for increased volatility.
Spiralling Market; Spongy Economics
We have long argued that current market levels owe more to central bank liquidity and to the suppression of natural risk premia than they do to underlying fundamentals. Even so, we were impressed by the magnitude of the move in €//CHF following the surprise abandonment of the one-way peg by the SNB last week.
If the cessation of ‘exceptional and temporary measures’ by a central bank with assets equivalent to just 0.5% of world GDP produces such turmoil, what sort of move should we expect if central banks more broadly were to attempt a return to ‘normal’ policy?
This short note attempts to answer that question by – rather speculatively and perhaps contentiously – drawing 12 conclusions from the SNB episode. They are deliberately rather brief and assertive, in part because they draw upon a body of arguments we have made elsewhere:
1. Markets are still awash with central bank liquidity. The ‘appearance’ of a return to normality was just that. ‘Fair value’ for most assets lies far below current market levels.
2. That abundance of liquidity is pushing down global bond yields. While many of the flows into CHF seem to have been short covering, -0.75% deposit rates are clearly not providing much deterrent to inflows. This suggests that the relatively much higher yields on other safe havens, such as Bunds and Treasuries, may well prove better supported than traditional considerations would otherwise have allowed for.
3. Yet this rally seems unlikely just to be the result of overspill from anticipated ECB (and BoJ) QE. First, the move in the US – and US long end in particular – feels too great to be attributable simply to displaced flows from Europe without any link back to US fundamentals. More importantly, if these low yields were merely the result of global technicals, they should have resulted in a wave of corporate (and in principle government) borrowing and investment. Despite some cyclical improvement, such a wave has not been forthcoming. If anything, corporates now seem to be cutting back on capex following the decline in energy prices. We estimate that one quarter of all jobs created in the US since 2009 have been in states with large fracking exposures; a similar pattern seems to exist in Canada. Multipliers in businesses with links to energy may well prove to be much higher than those for the rest of the economy.
4. Not only are central bank policies having a disappointing effect on business sentiment and investment; they are failing even to revive inflation expectations. Figure 1 and Figure 2 show the successive impact of each additional $10bn of US QE on the ISM and on 5-year breakeven inflation. After a big improvement in ISMs during QE1, the effect of the subsequent QEs was much more muted. And long-term inflation expectations in the US were lower at the end of QE3 than at the start of it – even before the recent oil price fall. Consumer inflation expectations in Japan – which were never quite as low as is commonly thought – are no higher than they were pre-crisis (Figure 3).
5. Worse, inflation expectations have recently been falling faster than nominal yields, meaning that in many markets real yields have actually been rising (Figure 4). Some of this may be due to a market technical, namely investors’ abandonment of inflation-linkers as a positive carry ‘duration short’. But if survey-based inflation expectations follow the market – as they have done on many occasions in history (Figure 5 and Figure 6) – central banks may be forced into easing merely to maintain current stimulus levels, never mind to add more.
6. This raises the spectre of ‘competitive easing’ – a sort of global race to the bottom as central banks struggle to stave off fears of deflation, with any region found to be lagging seeing its currency appreciate sharply, and growth and inflation vulnerable to falls as a result. Once one central bank – such as the ECB – eases aggressively, others are forced to follow suit. Fixed income markets are already starting to price in just such actions across both DM and EM.
7. This combination of competitive easing yet decided ineffectiveness in reviving inflation expectations may make low core bond yields far more sustainable than is commonly assumed. If central banks ease, it justifies low bond yields. But conversely on any tightening, risky asset prices are now so distorted that they are liable to fall back sharply. If growth falters as a result – as seems all too plausible given continuing record levels of debt – this too may justify low bond yields, at least in the long end. We suspect that many credit investors who had previously ‘hedged’ their long credit positions by going short duration are now having to rethink their positions as a result.
8. Despite having growing doubts as to central banks’ ability to create durable economic growth, we remain convinced as to their ability to push up risky asset prices. The weakness in many risky assets in the second half of last year can be seen as a belated response to Fed tightening; now that the BoJ and probably the ECB are turning back on the QE taps, asset prices have rallied again (Figure 7).
9. But with the economic response so muted and valuations in markets inflated already, the benefits of doing so are dubious. While we do not doubt central banks’ abilities, we increasingly worry as to their commitment to propping up asset prices indefinitely. Just like the Swiss, they face an ever more obvious ‘Catch-22’: continuing with current policies risks being destabilizing, but on the other hand withdrawing is even more destabilizing.
10. The reason we face such a predicament is our increasing reliance upon credit expansion as an engine of growth. Initially a useful offset to declining productivity and ageing populations, the debt overhang has increasingly become a problem in itself. Critics like Andrew Smithers argue that balance sheet recession is unlikely given the move toward corporate and household releveraging. But this does not preclude the possibility that some underlying form of secular stagnation will continue to hold back investment, preventing a ‘normal’ recovery, and that the ongoing debt burden is itself an obstacle. There are already signs households and businesses are leery of further releveraging: despite record-low bond yields, US M&A is increasingly being financed through equities.
11. The overhang of debt helps to explain some of the asymmetries in the outlook. As our US economists argued recently, wealth effects seem all but nonexistent when markets are rallying, but represent an immediate problem the moment markets sell off. In principle, higher asset prices should make debt seem more sustainable. But the marginal propensity to spend of the wealthy who benefit from rallying markets is much lower than the propensity to spend of those who suffer when they sell off. When IBM announces another share buyback, for example, its shareholders are unlikely to spend their windfall price rise; conversely, the moment Tesco drops to junk, the cost-cutting it announces as a result is likely to have a very real effect on jobs and spending. It is becoming ever more apparent that the Japanese were not as slow and ineffective in responding to their credit bubble as is commonly assumed: we are all at risk of falling into a Japan-style liquidity trap. As one investor put it, “zero rates may well in time come to be seen as deflationary”. But it is not the zero rates themselves; it is the addiction to credit-financed growth that requires us to adopt zero rates if the system is not to implode.
12. In market terms, this all feels like a recipe for increased volatility. In principle, central banks ought still to be able to produce the same suppression of volatility as prevailed in 1H14, once again depriving markets of their mojo. And yet this feels unlikely. With our base case from the ECB now for less-than-fullymutualized bond purchases, we are a long way from “whatever it takes”. Similarly in Japan and China, you have to wonder whether further growth disappointments will result in still more easing in ever more desperate attempts to prop up the economy – or whether they too, like the Swiss, may decide that the spiral markets have embarked upon seems quite decadent enough already. For now, our preferred strategies typically feature long ATM vol positions vs actually selling OTM vol: investors are right to worry about the tails, but we think there is too much priced in there already. And if things really get out of hand, do we really think central banks won’t attempt one more sugar rush? As any Swiss roll maker will tell you, even if there’s no jam, you can always try layering chocolate on top.
In closing – and in the spirit of the baker’s dozen – we should note that there is a scenario in which almost all of this proves complete nonsense. Indeed, it’s quite a plausible one: it’s close to being the global consensus. This is that the drop in oil prices is the first truly effective QE, putting money into the hands of those who will actually spend it; that the resulting boost to consumption triggers a ‘normal’ cycle of hiring and associated wage increases, with lower interest rates finally taking effect; that the resultant fear of wage rises causes a backup in bond yields, confounding those who thought that nothing could make them rise; that the resumption of ‘normal’ growth allows debt to be repaid, cyclical equities to outperform once more, central banks to return to ‘normal’ policies, and markets to return to fundamentals. That, though, is why bakers make extra: there’s always at least one roll that doesn’t turn out the way the recipe book says it ought to.