Well, this is just fantastic in terms of previous posts setting up new posts.
So earlier this week we ran one piece that outlined a study Bloomberg’s Cameron Crise conducted to determine the effect of global central bank liquidity on 10Y Treasury yields and another post highlighting the most recent note from Deutsche Bank’s Aleksandar Kocic who employed a roadrunner reference to illustrate his point about “the inevitability of fiscal inertia.” Those two posts can be found here:
- “Don’t Believe The Hype”: 2 Charts Suggest Central Banks Are Not All Powerful
- Epic: One Strategist Explains Why This Market Is Like Wile E. Coyote
As a refresher, here’s what Kocic said:
While monetary policy has shown remarkable flexibility when it comes to innovation and adaptability to different market conditions, fiscal policy has remained rigid and resistant to change. When viewed in the context of other policy tools, the inevitability of the fiscal inertia is a fact of life, like a natural law, that despite all resistance, the market will have to accept at the end.
There is an essential difference between natural laws and the laws governing social and historical developments. Former have to be respected while the latter can be suspended and ignored for some time. There is an archetypal scene from cartoons which relies for its comical effect precisely on the confusion of these two concepts: A coyote walks floating in the air above the precipice, and it falls only after it looks down and becomes aware of how it has no support beneath its feet – as if it has momentarily forgotten the natural laws its body has to obey, and has to be reminded of them
The optimistic outlook, based initially on the expectation of a swift fiscal stimulus and slow monetary policy, is now “levitating over the precipice” with everyone gradually “opening their eyes”.
In what may (or may not) be a happy coincidence, Citi’s Hans Lorenzen is out with a new piece that likens the market’s resilience in the face of what certainly looks like the beginning of the end for the central bank liquidity backstop to “a Wile E. Coyote moment.”
In other words, Lorenzen is taking the cartoon metaphor that Kocic says applies more to fiscal policy than to monetary policy, and applying it to… well… to monetary policy.
As usual, Lorenzen is writing from the perspective of credit markets, but he uses the S&P to make his point which, simply put, is this: markets have run off a cliff and the fact that they are temporarily suspended in mid-air (like Wile E. Coyote) will give central banks a false sense of confidence that will subsequently goad them into tightening further. But to quote Kocic again, “that system works only if no one opens his eyes.”
Here’s how Lorenzen puts it:
We think there is a growing chance that the credit market runs into a Wile E. Coyote situation, where a lack of instantaneous responsiveness in asset prices goads the global central banks to tighten until they reach what only with hindsight will prove a point of no return – or rather negative returns – for markets.
Read below as Wile E. Coyote becomes forever enshrined into the central bank/markets debate…
At escape velocity or a Wile E. Coyote moment?
You don’t need to listen too carefully to hear the baby steps of central banks heading for the exits. As our economists have reported, the mood among policymakers at the IMF-World Bank Spring meetings was upbeat with many seeing upside risks to global growth, despite an expectation of gradual monetary policy tightening. The recent weakness in US hard data is mostly viewed as a seasonal blip.
Low core inflation may prevent central banks from declaring outright victory. Nonetheless, it would be a major battle won if the implication of recent market resilience is that the central banks can quietly withdraw without causing a collapse in the asset prices that they have lifted.
In markets that idea seems to be gaining traction. Yes, valuations do look stretched to some – ask billionaire investor Paul Tudor Jones, who argues that the stock market has never been so highly valued relative to the size of the economy (Figure 1) or hedge fund manager Paul Singer, who, not too long ago (FT 16 Aug 2016), made the case that the bond market is in the biggest bubble in history. But with each passing day, we sense the fear of central bank policy tightening in risk assets, such as credit, is diminishing.
Central bankers will have noticed that compared to the extreme sensitivity across global financial markets that the Fed experienced barely 18 months ago, the reaction to FOMC jawboning redirecting the market towards a rate hike already in March was but a ripple. Indeed, the strong link between market performance and the Fed’s balance sheet finally seems to have broken down in the second half of last year (Figure 2).
Similarly, markets have taken the ECB’s decision last December to reduce the pace of asset purchases from €80bn to €60bn per month and the partial shift away from a negative bias in the outlook, in their stride.
But market confidence is likely to beget central bank confidence.
Our Eurozone economists expect the ECB will taper asset purchases from the current run rate of €60bn per month during the first half of 2018 , implying about €150bn of QE next year in total. That means buying about 0.6% of the outstanding in the European securities market compared to more than 3% this year and 4% last year. Their base case is that there will be no hike to deposit rates until asset purchases have ended.
Simultaneously, our US economists predict that the Fed will taper the reinvestment of maturing bond holdings from late this year or early next year. They expect the Fed to allow a monthly run-off rate in the portfolio starting at $10bn per month building up to $30bn per month.
In many ways the story line resembles the old tale about the boy who cried wolf. Pundits have fretted about each of the three Fed hikes, seen risks to the ECB dialling down QE, and warned about rising real interest rates and outflows as a result of negative total returns for the longest time. And yet, even with “tail-risk scenarios” like Brexit and a Trump election materializing, so far nothing has been able to really derail the rally in risk assets, such as credit, more than temporarily. The reaction to the result of the 1st round of the French Presidential election was another clear reminder of the pain trade in a market with more money than assets to buy.
And with the shift in the outlook over the last 12 months is it just possible that economic recovery can now close the gaps in historic relationships with valuations? For the first time since 2012, we’ve actually seen economists, including our own, upgrading their growth forecasts (Figure 3).
We remain very sceptical that this will happen. To our minds, asset prices are ultimately still much more reliant on central bank balance sheet expansion than recent experience might suggest. Here’s why.
QE effect can’t be really be discounted while it is still ongoing
The most obvious reason it is too early to dismiss the importance of QE now is that it is still happening on a large scale. Our metric of the increase in central bank security holdings globally has fallen from the peak last year, but it is still running at a level that in the past has been consistent with stable to slightly appreciating risk assets (Figure 4 and Figure 5). The S&P may have delinked from the Fed, but we’re not yet convinced markets have delinked from our global metric.
In Europe, in particular, the ECB QE has left hundreds of billions of euros more in deposits earning no or negative yields (Figure 6) 3 – and the story is very similar in Japan. With short-dated, risk-free instruments like 2-year Schatz yields more expensive than ever, and real yields negative beyond the next 30 years, the inducement to take greater risk in other asset classes in the absence of apparent and immediate negative catalysts is very strong. Even when central purchases stop, the opportunity cost on those newly created deposits will remain high until rates go up, providing indirect support for risk assets in the absence of obvious negative catalysts for some time.
We are also cautious about the argument that ECB tapering next year is already consensus and therefore should not impact asset prices. Granted, in a rational market you’d expect participants to base current investment decisions on their expectations for the future – including the path for monetary policy. So on paper anticipated future policy changes should be in the market price already.
But as Figure 4 and Figure 5 both clearly illustrate, in practice there is little evidence that market prices have consistently been able to preempt future changes in the pace of asset purchases (even when it has been preannounced) over the last seven years. Mostly, it seems like the relationship is pretty much simultaneous.