Earlier this week, we brought you “A Psychedelic Trip Through Surreal Markets – Hans Is Bringin’ The Shrooms.”
In that post, Citi’s Hans Lorenzen took you on a colorful trip through the mind-bending, Salvador-Dali-ish investment landscape in which we’ve all been forced to trade since the crisis ushered in an era of unprecedented monetary policy experiments.
Presentations from Lorenzen and his colleague Matt King are spiritual journeys for those of us who understand how truly surreal the world has become in the post-crisis
error era and Citi’s dynamic duo of credit strategists can be counted upon to make the trip even more LSD-ish than it already is by painting everything in psychedelic colors. Here’s an example:
One of King and Lorenzen’s accomplices is Joseph Faith, who co-produces a lot of these notes but who for whatever reason just doesn’t have the same name recognition. So shoutout to Joseph – your contributions are officially acknowledged.
On Friday, Faith and King have something new out, called “Markets Un-Balanced”.
The message is familiar, but that doesn’t make it any less important. Here’s King and Faith on the Fed’s hawkish lean and aggressive rolloff plan that came despite Wednesday’s lackluster inflation print:
Yet the Fed’s apparent disregard for low inflation pales into insignificance compared with the scale of their balance sheet reduction plans. The eventual $50bn monthly target announced for reducing reinvestments of their Treasury and MBS holdings was more aggressive than both consensus and our economists anticipated (we had been looking for $30bn/month). Admittedly, the FOMC plans to start slowly, has given itself some leeway in terms of when exactly the balance sheet run-off will begin, and has left open the option of halting or even reversing the process should conditions warrant it. Yet, given the references to it starting “relatively soon”, and the explicitness of the guidance as to the plan, our economists believe that September is the most likely start date for cutting reinvestments.
As we’ve noted in the past, in recent years asset price moves have displayed a high degree of correlation with central bank liquidity additions. Central bank buying has reduced the net amount of securities (in DM) the market needs to absorb, both this year and last, to near zero; we think this has played a critical role in propping up valuations at elevated levels.
Next year looks very different. We project that the private sector will have to absorb c.$1tn of securities – the highest number since 2012. The main driver for this is our anticipated reduction in ECB purchases from €780bn this year to €150bn in 2018. The faster pace of Fed balance sheet reduction we can now expect cements our impression that next year will see a big shift away from the current status quo. Assuming that Fed balance sheet reduction begins in September, the US market will have to absorb a further $450bn of supply in addition to the gap left by the ECB.
They go on to posit several possibilities for why central banks would even consider reducing their balance sheets in the current environment, but ultimately, King and Faith conclude that “rather than theorize,” it’s better if they “just plot global central bank purchases against changes in credit spreads and equities”:
We find an effect that is strong, global, and contemporaneous. Asset prices have rarely been able to pre-empt future changes in the pace of purchases, even when these have been announced in advance, over the last seven years. We think this is unsurprising when one set of buyers is so completely distorting the market.
The bottom line: the flow of CB liquidity is still present, so it’s not entirely surprising that risk assets haven’t sold off.
Indeed, as BofAML noted earlier this week, the Big 4 central bank’s have expanded their balance sheets by 11% this year:
The real test will come when the market has to actually absorb the $1 trillion in supply not taken down by central banks in the year ahead.
To sum up, here are the bullet points from King and Faith’s note:
- It’s not just the Fed that won’t be re-investing — The Fed’s planned balance sheet reduction, coupled with ECB tapering, seems likely to destabilize markets sufficiently that we think they will be unable to complete it.
- It’s the flow, not the stock (or the announcement) — That said, our models suggest markets are unlikely to react until the reductions in purchases are actually implemented. This is in stark contrast to the widespread presumption of immediate and full discounting.
- Multiple equilibria — This leaves investors struggling to reconcile significant longer-term negatives with what remains an almost overwhelming technical for now. We dislike the risk-reward, but can’t rule out that markets will remain in their current un-balanced state a while longer.