Earlier this week we discussed a chart from Citi's Hanz Lorenzen, which we said may be the "scariest chart for central banks" and showed the projected collapse in central bank "impulse" in coming years as a result of balance sheet contraction, and which - if history is any indication - would drag down not only future inflation but also risk assets. As Citi put it "the principal transmission channel to the real economy has been... lifting asset prices" to which our response was that this has required continuous CB balance sheet growth, and with the Fed, ECB and BOJ all poised to "renormalize" over the next year, the global monetary impulse is set to turn negative in the coming year.
Today, after a nearly three month absence, our favorite market strategist, Citi's Matt King is back with a note which confirms our suspicions.
In "Markets un-balanced" he warns that "the Fed’s planned balance-sheet reduction, coupled with ECB tapering, seems likely to destabilize markets sufficiently that we think they will be unable to complete it." And yet there is a paradox: since by definition central-bbanker intervention has broken the market, and thus its discounting abilities, King warns that the repricing may not take place until it is too late to step back: "our models suggest markets are unlikely to react until the reductions in purchases are actually implemented. This is in stark contrast to the widespread presumption of immediate and full discounting."
Here we can only ask rhetorically that if only believes that markets are indeed "broken" by central bank intervention, why would anyone assume that their key function - discounting - is still viable.
Here is King with his take, previewed here earlier in the week, on the biggest threat facing the market:
As we’ve noted in the past, in recent years asset price moves have displayed a high degree of correlation with central bank liquidity additions. Central bank buying has reduced the net amount of securities (in DM) the market needs to absorb, both this year and last, to near zero; we think this has played a critical role in propping up valuations at elevated levels.
Next year looks very different. We project that the private sector will have to absorb c.$1tn of securities – the highest number since 2012. The main driver for this is our anticipated reduction in ECB purchases from €780bn this year to €150bn in 2018. The faster pace of Fed balance sheet reduction we can now expect cements our impression that next year will see a big shift away from the current status quo. Assuming that Fed balance sheet reduction begins in September, the US market will have to absorb a further $450bn of supply in addition to the gap left by the ECB
His overarching question is one we have asked on various occasions: if balance sheet reduction is potentially so disruptive, why are the central banks so intent on it? He provides the following answers:
- First, the ECB has a particular problem in that it must either taper or abandon the capital key, otherwise it runs out of bonds to buy owing to its (admittedly selfimposed) 33% issuer-and-issue limit.
- Second, central banks generally seem to be in denial about the magnitude of the effect their purchases are having on markets. They acknowledge the general rise in asset prices, but fail to appreciate the sheer extent to which investors have become obsessed with “the technicals" and are buying despite a lack of belief in fundamentals or valuations.
- Third, central banks tend to presume their impact is concentrated locally; we think it works globally.
- Fourth, central banks tend to assume that it is the stock of QE that is stimulative, when all our models suggest that it is the flow (or even the change in the flow).
- Fifth, central banks still cling to the textbook model in which the market discounts all available information ahead of time, meaning that by the time they actually come to do their reduction, provided they’ve telegraphed it beforehand, the effect is already priced in. Unfortunately they seem to have neglected the textbook footnote that states that markets function this way only when they are deep and liquid. That might have been a reasonable description of pre-crisis markets; it seems a deeply unreasonable assumption for post-crisis markets in which leverage is constrained and one set of buyers have come along and absorbed virtually all of the world’s net new issuance.
- Sixth, most central bank studies of the effects of QE have concentrated on assessing its impact on government bond yields. We think this is hard to measure. On the one hand, central bank purchases clearly push prices up and yields down. On the other, if the purchases raise inflation expectations (as they are supposed to do), they push prices down and yields up. We think it is much easier to see the effects in equities and credit – via the very ‘portfolio balance’ effect which the central banks were aiming for – but few people look for it there.
Which brings us to the two charts in question:
As such, rather than theorize, we just plot global central bank purchases against changes in credit spreads and equities. We find an effect that is strong, global, and contemporaneous. Asset prices have rarely been able to pre-empt future changes in the pace of purchases, even when these have been announced in advance, over the last seven years. We think this is unsurprising when one set of buyers is so completely distorting the market.
Finally, here is King on what can tip over the current stable market regime into one of selling:
Our metric of the increase in central bank security holdings globally has fallen from the peak last year (Figure 5), but it is still running at a level that in the past has been consistent with stable to slightly appreciating risk assets (Figure 6). So, as we argued last week, a faster-than-expected pace of Fed balance sheet reduction won’t necessarily disrupt the current benign market paradigm for the time being. Over time, though, we struggle to see how the market will be able to adapt to the scaling back of support from the Fed and the ECB without a significant adjustment in valuations. If the effect is as large as it has been historically, the implied market disruption is sufficiently large that we think they will need to rethink their plans.
So for now, we see credit (and risk assets more broadly) caught between two equilibria. On the one hand, there is the reigning paradigm of the central banks compressing risk premia near current levels, with a shortage of investable assets fuelling a widespread and potentially self-reinforcing reach-for-yield regardless of the underlying fundamentals. On the other, spreads are forced to confront the scaling back in central bank support, widening rather rapidly to pre-CSPP levels. The asymmetric risk/reward in € credit leaves it particularly vulnerable: even with the low volatilility in recent months, spread breakevens against realised vol remain near historic lows.
What might flip us from the first to the second? As far as European credit is concerned, ECB communication is likely to remain the most significant driver. Notwithstanding Constancio’s comment this week that a decision on tapering will have to be taken by “autumn, but certainly before the end of the year”, there’s still little to suggest that the ongoing debate between the hawks and doves in the Governing Council is shifting in the hawks’ direction. But, given how tight spreads are to fundamentals and, even more importantly, the ultimate trajectory of central bank support, we remain confident that the next major move for credit will be towards wider spreads.
But, given the uncertainty over timing, positioning for the spread widening we anticipate without giving up too much carry in the meantime is critical. In our latest outlook presentation, we argue that the best hope for doing this is to increase exposure to market segments where beta is priced most cheaply, while reducing elsewhere. With the ECB reducing purchases only next year and the Fed set to get off to a slow start, it seems possible recent market strength persists a while longer. And yet the Fed’s hawkishness this week to our minds adds to the likelihood that in markets a significant un-balancing (or perhaps that should be re-balancing?) is coming.
To all the central bankers out there, who hope that the market won't notice what they are doing once they start doing it, good luck.