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
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.”