Bank of America: "We Have Not Seen This Movie Before"

With just months left until the global central bank liqiudity supernova finally ends, and turns into a drain of cash ...

... Bank of America has published its latest Quantitative Tightening analysis, writing that whereas Quantitative easing was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed, "there is no doubt that quantitative tightening (QT) at times will lead to the opposite - i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1)."

However, the reason why all hell has not yet broken loose, is that we are still in this "intermediate phase" - i.e. on the road from QE to QT - where things remain orderly although as the BofA credit team writes, "technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).

Hence, as we slowly make the transition from QE to QT, we have already witnessed higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4). And this is just the beginning.

Of course, it will hardly come as a surprise to anyone paying attention that the reason why the markets haven't i mploded yet, and the reason why we are not yet experiencing the full effect of QT is that foreign central banks - the ECB and BOJ in particular - are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5), even if these two risk-boosting stimuli are gradually fading.

This push-pull equilibrium as defined last week by Jeff Gundlach, allows the system to persist in this unstable state indefinitely, because every time US yields rose too much due to QT and rate hikes, there would be large foreign inflows. "Hence, US yields would not increase too much and fixed income volatility remains moderate" according to BofA's Hans Mikkelsen. Preventing an out of control collapse in risk assets, whereas last week the ECB announced the end to QE, it also came out unexpectedly dovish by returning explicit calendar guidance and promising continued negative interest rates (NIRP) for a long period of time (Figure 6).

At the end of the day, the dovishness prevailed, sending the EUR plunging, as NIRP in the Eurozone works much like QE, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.

But while NIRP controls the short end doesn't the ECB needs QE to infludence the back end of the curve? Not really: with persistent negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9). That asserts bull flattening pressure on both rates and quality curves.

And this is where things get interesting, or as BofA notes, "we have not seen this movie before", because as Mikkelsen writes, "while QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long - certainly years."

What does all this mean in terms of practical credit trades? Here BofA is growing skeptical that a bullish credit trade will be appropriate as we continue to shift away from QE and closer to full-blown QT.

While we consider high grade credit spreads this year range bound - and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) - we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020.

This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate.

The only question is when will the algos, buybacks and occasional central bank intervention in stocks (mostly the SNB  and BOJ) that set the daily trading mood, finally concede what is coming, and let fundamentals and market logic finally reassert themselves.

Comments

Endgame Napoleon Quantify Mon, 06/18/2018 - 19:16 Permalink

Why can’t the Congress that was able to raise its pay to $185k in the Omnibus Bill manage to put Glass Steagall back together again after it fell off the wall, starting in the neoliberal Nineties? Answer: It is same reason they won’t do anything to stop the flow of illegal immigration, even though the USA has 101 million citizens out of the workforce, 78 million so underemployed that they are working gigs and 42 million EBT-qualified citizens & noncitizens who are womb productive, but not working full time, as they would exceed the income limits for that program if they did. We have all of these illegal aliens streaming in. We let in 1.5 million legal immigrants each year, many of whom get free EBT food, free rent, monthly cash assistance and up to $6,431 in refundable child tax credit money when they reproduce in America in single-earner households. As a result of maintaining this failed policy for decades, America has the biggest generation of working-age youth—ever—bigger than the Baby Boom. This massive Millennial generation is so underemployed that they are not contributing enough into the SS trust fund to support the smaller—but massive—Baby Boom generation. Letting in a gargantuan number of immigrants and paying them to reproduce while working part time, plus paying many millions of single-earner citizens to reproduce while working part time, has NOT worked to create a viable economy. It has created an even bigger generation than the vast Boomer generation. We already have the largest, young, working-age generation on record, and the US Congress will not allow anything to be done to change the failed policies that keep Americans permanently underemployed, undercutting the value of their labor by flooding the country with welfare-qualified workers who do not need higher pay or decent hours. This ensures that work never pays for anyone at the bottom but the womb productive who are paid for sex & reproduction by government to boost up their inadequate wages.  

In reply to by Quantify

Consuelo Mon, 06/18/2018 - 17:44 Permalink

"Henceas we slowly make the transition from QE to QT"...

 

You mean, as we skip from QE to QT and right into the final QE Supernova...?   Because everyone knows that is precisely where we're headed.

Oldguy05 Mon, 06/18/2018 - 17:51 Permalink

" when will the algos, buybacks and occasional central bank intervention in stocks (mostly the SNB  and BOJ) that set the daily trading mood, finally concede what is coming, and let fundamentals and market logic finally reassert themselves. "

NEVER!

francis scott … Mon, 06/18/2018 - 18:00 Permalink

"We have not seen this movie before."

DUH!

Americans are so helplessly stupid that they don't have a clue

how to think/react unless they can remember what someone

in a classic film did in a similar situation.

 

 

"Fasten your seat belt, Snorkler.    

 It's going to be a bumpy night"

 

 

JibjeResearch Mon, 06/18/2018 - 18:03 Permalink

The Fed will raise rate as high as possible to destroy the EMs without hurting the US Market.

A 4.5% fund rate would do it..., I think the Fed will make a U-turn at around 4%.

looks so real Mon, 06/18/2018 - 19:00 Permalink

They say it publicly QE will stop but stealth fixing of any impending cracks will be sealed buy flash digital cash.I read the Pentagon spent 20 trillion dollars that was unaccounted for like where did that money come from? No body knows technology makes every problem that easy to fix.All hail Deep State!