End of easy money results in $410 billion global financial shock
The global move away from easy money is poised to gather pace as a campaign of pandemic bond buying by central banks reverses, threatening another shock to global economies and financial markets.
Bloomberg Economics estimates that policymakers in the Group of Seven countries will shrink their balance sheets by about $410 billion by the rest of 2022. That’s a sharp turnaround from last year, when they added 2 $.8 trillion – bringing the total expansion to over $8 trillion since COVID-19 happened.
This wave of monetary support has helped sustain economies and asset prices during a pandemic crisis. Central banks are pulling it back – belatedly, some critics say – as inflation hits multi-decade highs. The dual impact of shrinking balance sheets and rising interest rates adds to an unprecedented challenge for a global economy already impacted by Russia’s invasion of Ukraine and new COVID-19 lockdowns by the China.
Unlike previous tightening cycles where the US Federal Reserve was the only one to reduce its balance sheet, this time others are expected to do the same.
The Bank of Japan stands out and remains committed to asset purchases – it has had to intensify them in recent weeks to defend its policy of controlling bond yields. The yen weakened to a 20-year low in the process.
Their new policy, known as quantitative tightening – the opposite of the quantitative easing that central banks have turned to during the pandemic and the Great Recession – will likely drive up borrowing costs and dry up liquidity.
Already, rising bond yields, falling stock prices and strengthening dollar are tightening financial conditions, even before the Fed’s efforts to raise interest rates are in full swing.
“This is a major financial shock for the world,” said Alicia Garcia Herrero, chief economist for Asia-Pacific at Natixis SA, who previously worked for the European Central Bank and the International Monetary Fund. “You are already seeing the consequences of declining dollar liquidity and the appreciation of the dollar.”
The Fed is expected to raise rates by 50 basis points at its policy meeting on May 3-4 and several times thereafter, with traders seeing a tightening of around 250 basis points by the end of the year. Authorities are also expected to start shrinking the balance sheet at a maximum rate of $95 billion per month, a faster change than expected at the start of the year.
The US central bank will achieve this by allowing its holdings of government bonds and mortgage-backed securities to mature, rather than actively selling the assets it has purchased. Policymakers left open the possibility that they could, at a later stage, sell mortgage bonds and revert to a portfolio consisting entirely of Treasuries.
In 2013, the Fed’s balance sheet plans surprised investors and triggered an episode of financial turmoil known as the “taper tantrum”. This time around, the policy was well telegraphed, in the United States and elsewhere. Asset managers have had time to assess the effects, which should make a heartbreaking shock to the markets less likely.
First in history
So far, the Fed’s proposed runoff has led investors to demand a cushion for the risks associated with holding long-term US Treasuries. The term premium — the extra compensation investors need for holding longer-maturity debt rather than continually rolling over shorter-term bonds — has increased.
Fed officials said QE helped lower yields by lowering the term premium, providing a cushion for the economy during the 2020 recession. Investors expect QT to do the opposite .
The pace of unwinding the Fed’s balance sheet is expected to be about twice as fast as in 2017, when it last reduced its holdings.
The magnitude of this contraction and its expected trajectory is a first in the history of monetary policy, according to fund manager Gavekal Research Ltd. Didier Darcet.
Others are going in the same direction.
The European Central Bank has announced that it will end QE in the third quarter, a timetable complicated by the fallout from the war in Ukraine. The Bank of England has already started to shrink its balance sheet by ending gilt reinvestments in February. Another rate hike is expected in May, bringing the key rate back to the threshold where policymakers will weigh the active selling of their asset portfolios. The passive reduction of its balance sheet by the Bank of Canada – choosing not to buy new bonds when the ones it holds come due – is expected to see its holdings of government debt shrink by 40% over the next two years.
China, which shunned QE during the crisis, has shifted into stimulus mode with targeted measures to provide financing to small businesses as it battles to contain the country’s worst COVID-19 outbreak since 2020 Chinese leaders on Friday pledged stimulus to boost growth.
Investors fear the unknown as liquidity is drained from bond markets that have been awash with central bank money in a period dating back to the 2008 financial crisis. Markets like housing and cryptocurrencies that have soared Soaring in the easy money years will face a test as liquidity tightens.
“With all this central bank tightening already entering a downturn, it’s really going to be a question of whether central banks tip us into recession,” said Kathy Jones, chief fixed income strategist at Charles Schwab. & Co., which manages over $7. trillion in total assets.
Some are cutting back on risky assets in anticipation.
Robeco Institutional Asset Management has been buying short-term bonds and trimming its holdings of emerging market high yield bonds, credits and hard currencies, as it expects the economy to slow down or even enter recession this year. .
Wealth manager Brewin Dolphin Ltd. becomes more defensive as it seeks to reduce its equity holdings in the event of a rally.
Citigroup strategist Matt King said cash flow is much more important and has a better correlation with stocks than actual returns. He estimates that every trillion dollars worth of QT will equate to about a 10% drop in the stock over the next 12 months or so.
“Watching the paint dry”
For Chris Iggo, Chief Investment Officer at Axa Investment Managers, now is a good time to buy bonds as a safety hedge in case stocks react badly to the QT and rising interest rates.
“Stocks tend to go down when the economy is really crashing and earnings are down. That’s preceded by higher rates,” Iggo said. “On this timeline, we’re not there yet. But slowly adding fixed income as yields rise will eventually provide more effective hedging in a multi-asset portfolio when and if equity returns turn more negative.
Central bankers have argued that shrinking their balance sheets by allowing bonds to retire, rather than selling them sharply, shouldn’t be too disruptive. The process has previously been described by Fed Chair and current US Treasury Secretary Janet Yellen as akin to “watching the paint dry”.
Yet the combination of QT, rising short-term rates, a strong dollar, rising commodity prices and US fiscal contraction presents the US and the world with a headwind. major, said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments.
“It’s a lot for the economy to manage,” Tannuzzo said. “We don’t need to have a recession to say that growth will be quite slow at the end of the year.”
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