Central Bank Liquidity and the Repricing of Risk (Part I)

The research team at Montaka Global recently explored some of the major dynamics occurring in the fixed income markets, how they may impact stocks and potentially reveal some perspectives on what may lay ahead in 2019. Below is a summary of some of the key thoughts and observations that we explored.

Central Banks are Tightening After an Extended Period of Balance Sheets Expansion 

• The U.S. Federal Reserve Bank (the Fed) has been the most aggressive central bank in the world with respect to normalizing monetary policy following the 2008/2009 Global Financial Crisis (GFC) by ending Quantitative Easing (QE) and raising interest rates.
• The Fed officially ended QE in October 2014 and raised rates for the first time post crisis a year later (December 2015). This week (December 13, 2018) the ECB officially announced it would also stop QE from January 2019 and wouldn’t raise rates until October 2019 at the very earliest. The Bank of Japan (BoJ) has a less traditional QE program in that it targets 0% yield (+/-20bps) on its 10-year government bond and has allocated ¥80 trillion (~$710 billion) to the program which is currently about halfway through.
• The effect of all these QE programs was nothing short of an explosion in the size of central bank balance sheets as liquidity was pumped into the system in order to provide support to financial markets and the economy.
• As can be seen from the chart below, all of the major central banks (Fed, ECB, BoJ) through their various QE programs have added ~$10 trillion in liquidity to the system, taking their collective balance sheets to ~$15 trillion, which represents a threefold increase from $5 trillion.
  • As context, the current market capitalization of every listed stock on the S&P 500 is $23 trillion, so the $10 trillion of central bank liquidity represents ~43% of that.

            Central Bank Balance Sheets Tripled Following the GFC to ~$15 Trillion

• As noted above, the Fed has been the most aggressive central bank in unwinding monetary policy and commenced its balance sheet unwind / reduction program in October 2017 which gradually increased every quarter until it hit full speed in October 2018. The Fed will now allow $50 billion of treasury bonds, agency debt and mortgage-backed securities to roll off its balance sheet and will need to find a new home (i.e. cash), which may have been invested in other assets (like corporate bonds, equities, etc.), effectively draining liquidity back out of the system.
• As can be seen from the chart above, the MSCI All World Equity Index (dark blue line) has drifted lower as the Fed balance sheet has contracted in 2018.
  • The Fed increased its balance sheet from ~$870 billion in August 2007 (pre-GFC) to $4.5 trillion in September 2017, under its balance sheet unwind program the size of the Fed balance sheet has fallen by ~$400 billion to ~$4.1 trillion in December 2018.

Central Bank Tightening Programs are Only Beginning to Have an Impact on Net System Liquidity

• Currently the major central bank liquidity draining programs comprise of the Fed’s balance sheet unwind (hit top gear in October 2018), the ECB’s cessation of QE (from January 2019), plus the BoJs increased target range around its 0% 10 year bond yield (from +/-10bp to +/-20bp).
• Taken in aggregate, the major central banks will have consistently drained liquidity from the system for 12 months (12-month rolling flow) starting Q2 2019 (April 2019) for the first time in over a decade (since before the GFC). Whether this corresponds to continued volatility or whether the market adapts to the liquidity removal in a more orderly fashion remains to be seen.

            Pace of Central Bank Balance Sheet Tightening 

The Market is Not Expecting the Fed to Hike for Next 3 Years Starting 2019

• The Fed has raised interest rates eight times since December 2015 (25bps each) and is expected to increase for the ninth time on December 19, 2018. However, beyond this (starting 2019) the market has completely discounted any rate-hikes for the following 3 years and is in fact pricing a slight chance of a rate cut during this period
  • The median of the Fed dot plot indicated the FOMC expects to raise rates 3 times in 2019 with the market pricing zero hikes for that period  

            Rate Hikes Implied by Fed Fund Futures 

We will conclude this blog entry in Part II which will be posted in the coming days.

Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.