Global central banks certainly haven’t succeeded in creating the type of robust recovery they ostensibly set out to facilitate in the wake of the crisis.
At the very least, the coordinated effort in monetary insanity has taken a lot longer to “work” than its architects anticipated and that’s in no small part attributable to the idea that the transmission mechanism doesn’t work the way they thought it did.
Even if you want to argue that recent data out of Europe, Japan, and Canada suggests things are finally turning around in earnest, you’d be hard pressed to find much in the way of convincing evidence to support a contention that ultra accommodative policies have had their desired effect on CB inflation targets.
Part of the problem is that their targets are too narrowly defined and exacerbating the issue are structural deflationary forces, perhaps the strongest of which is embodied in Jeff Bezos, the previously diminutive nerd who now looks like he walked out of an Expendables sequel:
Of course there’s no shortage of inflation in financial assets – and that gets us back to the transmission mechanism point. Simply put, the effect of plowing trillions in liquidity into the system was immediate and quantifiable in terms of asset prices but delayed and difficult to pin down in terms of the real economy. Who knew, right?
The final act of this quest to drive investors down the quality ladder into riskier and riskier assets is playing out before our very eyes as yields on things like Mongolian bonds test record lows, yields on € junk bonds converge with yields on U.S. Treasurys, and the difference between stock dividends and yields on corporate debt invert (“stocks for income”).
This of course raises the following question: what happens when central banks start to roll back the stimulus?
So what we want to do with the rest of this post is simple. First, we’ll show you an annotated chart from Goldman that illustrates the effect Fed QE has had on USD IG and HY spreads and then, we’ll close with the bank’s benign take on what happens when the good folks at the Eccles building start unwinding the balance sheet.
Here’s the chart:
And here’s why Goldman is ready to “err on the side of optimism” (because we’d hate to leave you on a sour note):
While there is no doubt that quantitative easing has fueled years of search for yield in fixed income markets, and thus compressed risk premia (Exhibit 3), we are skeptical that a well-managed quantitative tightening process would cause a large reversal of the positive impact that the Fed’s balance sheet expansion had on spreads from late 2008 to early 2014. For one, the process will likely be gradual and will not take the size of the balance back to its pre-crisis level. Second, and as we have repeatedly emphasized over the past few years, the drivers of the tightening of monetary policy – even unconventional policy – matter more than the tightening itself. As long as the balance sheet run-off is responding to a friendly growth/inflation mix, we think spreads will remain well-behaved.
But around this relatively benign baseline view, we highlight two risks: one on the technical side and one on the fundamental side. On the technical front, the combined effect of a higher term premium and tight spread levels will likely put downward pressure on corporate bond price returns and could therefore cause a supply/demand dislocation, driven by mutual fund outflows for example. This risk is relatively high in the IG market, which has record high fund inflows this year. But barring an abrupt repricing of the term premium, we would expect any technical dislocation to be relatively short-lived.
On the fundamental side, and beyond the risk of a miscommunication, similar to the 2013 “taper tantrum” episode, the key risk is that an unexpected inflationary shock causes a faster-than-anticipated normalization of the Fed’s balance sheet. Given the continued weakness in inflation, this risk remains remote, in our view