It's The Fed, Stupid; Why Kuroda And Draghi Are No Match For Quantitative Tightening

Earlier today, Deutsche Bank - who last week won the sellside race to coin a new term for the unfolding EM FX reserve unwind - took a close look at the end of the "Great Accumulation" and what it means for asset prices and DM monetary policy going forward. Here was Deutsche Bank’s "profound" takeaway:

Less reserve accumulation should put secular upward pressure on both global fixed income yields and the USD. Many studies have found that reserve buying has reduced both bund and US treasury yields by more than 100bps. 


Declining FX reserves should place upward pressure on developed market yields given that the bulk of reserves are allocated to fixed income. 


This force is likely to be a persistent headwind towards developed market central banks’ exit from unconventional policy in coming years, representing an additional source of uncertainty in the global economy. The path to “normalization” will likely remain slow and fraught with difficulty.

But that, as it turns out, is not all. 

As you might imagine, EM capital flows have tracked the Fed, BOJ, and the ECB’s balance sheets quite closely (albeit with a lead) in the post-crisis, QE-dominated world.

What’s interesting however, is that there now appears to be a disconnect:

What accounts for that, you ask? Well, according to DB (and this isn't exactly surprising) the simple fact is that EM inflows/outflows are far more dependent on the Fed than they are on the BOJ and ECB and that means that a dovish Kuroda and Draghi will be no match for an even semi-hawkish Fed and that could be very bad news for EM flows considering how far ahead the Fed is in terms of approaching a rate hike cycle and considering, as we noted earlier, that DB's previous answer to the EM FX reserve liquidation quandary was that perhaps "other central banks [will] come in to fill the gap that the PBoC is leaving [as] China’s QT would need to be replaced by higher QE elsewhere, with the ECB and BoJ being the most notable candidates". From DB:

Given the reliance of EM reserves on QE-enabled financial flows since the 2008 crisis, the speed of reversal should be a key driver of reserves trends going forward. EM capital flows have indeed had a strong relationship with G3 central bank balance sheet growth with a two-quarter lead (Figure 15), given that market pricing anticipates shifts in QE. Projecting G3 balance sheet trends thus offers some clues. In our most hawkish scenario, the Fed stops reinvestment by mid- 2016 and the ECB and BoJ stop QE by September and December 2016, respectively. A more dovish scenario might see the Fed reinvesting ad infinitum and the ECB and BoJ extending QE purchases until end-2017.

Worryingly, EM capital flows are already significantly undershooting the projection from the hawkish scenario. A constructive take on this would be that EM outflows have overreacted and could give way to inflows again as global liquidity conditions remain more accommodative than feared. The less constructive view is that the Fed balance sheet simply matters far more for EM, with liquidity provided by the ECB and BoJ a poor compensation for the Fed’s retrenchment. Indeed, Figure 16 suggests this to be the case, with EM flows tracking the fall in Fed balance sheet growth closely of late. The hawkish scenario of Fed stopping reinvestment next year would suggest that EM flows can get weaker, while even a more dovish scenario of a constant Fed balance sheet would not be enough to lift inflows again. 


In other words, even under DB's dovish scenario for the Fed, in which Yellen reinvests the proceeds from maturing securities forever, EM capital flows will likely remain negative, putting perpetual pressure on FX reserves. And as should be abundantly clear by now, perpetual pressure on FX reserves means the unwind of the "Great EM Accumulation" continues unabated until either the Fed launches QE4 or else stands by while the world's emerging economies burn through their cushions and careen into crisis. 

Finally - as noted earlier in "ABN Amro Warns There Is A 40% Chance Mario Draghi Expands ECB QE As Soon As This Week" - 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, is and will always be the Fed. For a quick explanation of this, re-read "Why QE4 Is Inevitable."