Global liq­uid­ity drought is suck­ing the life out of mar­kets

As the US Fed­eral Re­serve and cen­tral banks around the globe con­tinue tight­en­ing, pre­pare for more fire­works, writes Tom Rees

The Sunday Telegraph - Money & Business - - Front page -

Af­ter a decade of re­lent­less cen­tral-bank mon­eyprint­ing, it’s dif­fi­cult to imag­ine how mar­kets and the world econ­omy could have crawled away from the wreck­age of the cri­sis with­out quan­ti­ta­tive eas­ing (QE). The first rounds were un­charted ter­ri­tory; an ex­per­i­ment cen­tral banks could not af­ford to get wrong. Pol­i­cy­mak­ers in­jected much-needed liq­uid­ity into the fi­nan­cial sys­tem by buy­ing tril­lions of dol­lars of gov­ern­ment bonds, pump­ing in money to stim­u­late the econ­omy. Bal­ance sheets at the Fed­eral Re­serve, the Euro­pean Cen­tral Bank and the Bank of Eng­land bal­looned and Qe-hooked mar­kets be­came de­pen­dent on the pro­gramme.

Now the Fed has be­come the first to step into an­other un­known. The US cen­tral bank is un­wind­ing its Franken­stein ex­per­i­ment and stricken mar­kets are the un­will­ing guinea pig.

This year will mark the first time global cen­tral banks’ bal­ance sheets will shrink, drop­ping to an es­ti­mated $14.6 tril­lion (£11.4 tril­lion). More than $1.2 tril­lion will have been sucked out of the fi­nan­cial sys­tem by the end of the year since QE’S peak in early 2018, ac­cord­ing to data from Her­mes In­vest­ment Man­age­ment. In­vestors fear wind­ing down the Fed’s

$4.5 tril­lion bal­ance sheet is qui­etly stran­gling the life out of mar­kets. Quan­ti­ta­tive tight­en­ing – the rev­er­sal of QE – has be­come fund man­agers’ sec­ond-big­gest con­cern af­ter the trade war, ac­cord­ing to Bank of Amer­ica Mer­rill Lynch. They fret that cen­tral banks could trig­ger a liq­uid­ity drought that will fin­ish off the floun­der­ing bull run. Mar­kets are urg­ing the Fed, which once promised an in­con­spic­u­ous end to QE, to re­think its gung-ho pol­icy.

To mend the bat­tered fi­nan­cial sys­tem af­ter the cri­sis, the Bank of Eng­land bought gilts in its QE pro­gramme while the Fed gob­bled up Trea­suries, US gov­ern­ment debt. QE pushed in­vestors away from safer bonds into riskier as­sets, low­ered in­ter­est rates fur­ther and helped shore up badly bruised con­fi­dence.

Janet Yellen, the for­mer Fed chair­man, pre­dicted un­wind­ing the bal­ance sheet of bonds built up dur­ing QE would be like watch­ing paint dry. The first year of the bal­ance sheet run-off in the US has been any­thing but. A record 93pc of all as­sets lost value in dol­lar terms in a dev­as­tat­ing 2018 for in­vestors, Deutsche Bank data cal­cu­lated in De­cem­ber. Last year’s stocks slump was pinned on a cock­tail of wor­ries from trade ten­sions to a dark­en­ing global growth out­look. But some fear that it was no co­in­ci­dence that a tur­bu­lent fi­nal quar­ter for mar­kets co­in­cided with the mo­ment that QE tipped into QT glob­ally.

James Fer­gu­son, of Macros­trat­egy Part­ner­ship, ar­gues the with­drawal of QE and liq­uid­ity from mar­kets has started to have a dev­as­tat­ing ef­fect. “The only thing that would make ev­ery­thing go down across the board – with­out any ob­vi­ous bad news – is tak­ing the money out,” he says. “There is much less money com­ing in so ev­ery­thing gets marked down.”

The ris­ing tide of QE lifted all boats on mar­kets, un­der­pin­ning a decade-long and at times eu­phoric bull run. But now the sup­ply of money from cen­tral banks is drain­ing away.

“It is prov­ing to be the ex­act op­po­site of QE,” says Fer­gu­son.

In QT, cen­tral banks ei­ther let their port­fo­lio of bonds ma­ture or sell the debt. The Fed has al­lowed as much as $50bn a month of its bal­ance sheet of bonds to ma­ture, tak­ing money out of the sys­tem as gov­ern­ment debt finds new buy­ers. The Euro­pean Cen­tral Bank also joined the Bank of Eng­land in turn­ing off the QE taps in De­cem­ber de­spite an un­steady end to the year for the eu­ro­zone econ­omy. Their bal­ance sheets re­main steady.

“We are see­ing this gi­ant suck­ing out liq­uid­ity from the sys­tem with the Fed rais­ing rates and re­duc­ing the bal­ance sheet,” ex­plains Eoin Mur­ray, head of in­vest­ment at as­set man­ager Her­mes. “The tip­ping point was Oc­to­ber. From Oc­to­ber on­wards, net global liq­uid­ity was start­ing to de­cline and that is quite im­por­tant.”

Other QT risks are ris­ing. Cen­tral banks kept yields on debt low with re­lent­less de­mand through QE, but the with­drawal from bond mar­kets is mak­ing bor­row­ing more ex­pen­sive for com­pa­nies. Re­duc­ing the bal­ance sheet at a rate of $50bn a month is thought to be the equiv­a­lent of a quar­terly rate hike. The rev­er­sal of QE will make the spikes in mar­ket volatil­ity, as seen in the fi­nal quar­ter of 2018, more likely, warns Sea­mus Mac Go­rain, in­vest­ment man­ager at JP Morgan As­set Man­age­ment. QE “damp­ened the im­pact of these volatil­ity events with this con­stant bid from cen­tral banks”, he ex­plains.

QT could also ex­pose cracks cre­ated by mar­ket-warp­ing poli­cies. Brian Singer, at in­vest­ment bank Wil­liam Blair, be­lieves that ETFS and other in­vest­ment strate­gies that have chased Qe-flooded mar­kets higher will strug­gle to adapt.

In­vestors fired a shot across Fed chair­man Jerome Pow­ell’s bow in De­cem­ber. The mar­kets blood­bath gath­ered pace amid fears that the Fed’s heavy-handed ap­proach would pull the rug from un­der in­vestors.

Pow­ell shocked mar­kets by ad­mit­ting that re­vers­ing QE was on “au­topi­lot”. The De­cem­ber rout that pushed US mar­kets to the brink of a bear mar­ket forced a hasty re­treat last week. He said: “We wouldn’t hes­i­tate to change it [pol­icy] and that would in­clude the bal­ance sheet.”

Mac Go­rain be­lieves the Fed has re­ceived the mes­sage loud and clear. “Of course it hasn’t been like watch­ing paint dry, it has af­fected mar­kets in a ma­te­rial fash­ion so I think the Fed is set­ting them­selves up to change the run-off.”

Pow­ell could prove a thorny ad­ver­sary for mar­kets, how­ever. He re­vived con­cerns last week by warn­ing that the bal­ance sheet will be “sub­stan­tially smaller”, sug­gest­ing fur­ther tight­en­ing.

Singer ex­plains that Pow­ell is not part of a grad­u­at­ing class of cen­tral bankers, in­clud­ing Yellen and the ECB’S Mario Draghi, that fo­cuses on sup­port­ing as­set prices, there­fore he is more will­ing to push through mar­ket pain.

“Jay Pow­ell is def­i­nitely not of that school. He un­der­stands what volatil­ity is and he’s not afraid of it.”

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