For years, major central banks such as the US Federal Reserve, Bank of Japan, European Central Bank and the Bank of England, among others, have been undertaking quantitative easing, or QE.
Be it bonds, corporate credit or stocks, they’ve been purchasing a lot assets, flooding the global economy with an abundance of cheap money.
Nothing quite demonstrates the scale of asset purchases than the chart below from Macquarie Bank, revealing the amount of asset purchased by major central banks going back to the end of 2014.
It’s been a lot, measured in the trillions of dollars.
Coinciding with this flood of central bank liquidity, global asset prices have been soaring, especially further out the risk spectrum.
High-yield debt and currencies have been in high demand while stocks have been relentlessly breaking record-high after record-high.
However, change is a coming.
As shown in the chart above, quantitative easing looks set to be replaced by quantitative tightening, or QT, by the end of this year.
With the US Federal Reserve now running down the size of its balance sheet — no longer replacing maturing assets with others — and other central banks starting to slow down asset purchases as well, instead of adding liquidity to the financial system, it will be taken away, albeit slowly.
“At a global level, monthly asset purchases peaked in late 2016 with a gradual further reduction likely over 2018,” says Macquarie.
“Assuming the Bank of Japan (BOJ) keeps its purchases constant at the pace seen in Q4 2017 over 2018, global purchases should fall to zero by end-2018. And assuming the BOJ reduces its purchases further in 2019, global purchases will be negative over 2019.”
Given what’s been seen in financial markets during the QE era, more than a few are concerned that the switch to QT could bring the opposite outcome, leading to declines in asset prices, especially in riskier assets.
“Many highly respected analysts and investors have suggested that the increase in asset prices over the past decade, including in 2017, remains a direct consequence of ongoing central bank asset purchases. And that as the pace of central bank purchases slows and then goes into reverse over the coming year or two, the yield curve in most countries will need to shift materially higher and many asset prices will come under significant pressure,” says Macquarie, referring to the concern being echoed by some investors.
“Or, in simple terms, ‘the central bank driven boom must be followed by a bust’.”
Macquarie says this perception is driven by many market participants believing that it is the flow of assets that is most relevant for yields and for risk assets.
“They argue that while the Fed began to taper in 2014, this reduction was offset by increased purchases elsewhere. But that now that other central banks are also about to go into reverse the inevitable day of reckoning will present itself soon,” it says.
So are financial markets about to receive their “day of reckoning”, seeing a rush to the exits as the central bank liquidity rug is pulled.
To Macquarie, the move from QE to QT is unlikely to see the end of the “buy the f***** dip”, or BTFD, mentality that has helped to push asset prices higher, at least in the first half of 2018.
“Despite the likelihood that the magnitude of global CB purchases will continue to slow over 2018, with the possibility that global purchases turn to sales, we feel that the combination of the gradual and well telegraphed changes to balance sheets, a negative European policy rate and near zero Japanese 10-year yields — as well as a myriad of structural forces such as demographics and pension funds need for yield — is likely to keep long within the range seen in recent years for at least the first half of 2018,” it says.
“This, combined with continued strong growth and profits, as well as the immediate flow through to profitability from the trump tax cuts, should continue to support asset prices over much of 2018.”
It points to the performance of US stocks and bonds since the US Federal Reserve began to slow asset purchases in 2014 to help explain this view.
“The Fed began to taper its purchases in early 2014, with flows turning negative in Q4 of last year,” it says. “But that despite the peak in US QE, the S&P 500 has increased by nearly 50% since January 14, while US 10-year yields have fallen by 50 basis points to around 2.50%.
Pointing to the chart below, Macquarie notes that despite a 35% reduction in central bank asset purchases last year, the S&P 500 still jumped by 18%.
“While many have attributed the bull run in global equities to central bank asset purchases, the link between the two has been loose at best,” it says.
While some may argue that was due to relentless speculation over potential US corporate tax cuts — something that has now subsequently been delivered — many will be hoping that the performance of US assets over the past few years despite fewer asset purchases from the Fed will be something of a lead indicator to what will happen in other regions in the year ahead.
We’ll find out whether that is the case as this unprecedented unwind of QE truly begins to kick in.
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