Revisiting The Only Thing That Matters In A Taper: Stock Vs. Flow Effects

With the ECB decision in the books, it’s worth briefly revisiting the QE “stock” versus “flow” debate.

Although you can add specificity and fancy language if you like, it boils down to a very simple question: is it the cumulative size of central bank balance sheets that matters (the stock effect) or is it the pace of the ongoing purchases (the flow effect) that’s important?

As a reminder, no one knows the answer to that yet. That’s how it works with things that are “unprecedented” like the post-crisis monetary policy response. When you do something unprecedented, you have no idea what’s going to happen when you undo it, because by virtue of that thing you did being unprecedented, the undoing of that thing is by definition unprecedented too. Here’s what Deutsche Bank wrote a couple of weeks ago:

We are likely to be nearing a low point for major market bond and equity vol, and if the catalyst is policy it will likely come from positive volatility QE ‘flow effect’ being more powerful than the vol depressant ‘stock effect’.

CB

Ok, so that’s the lens through which you might want to look at the ECB taper. Here are a couple of excerpts from a Goldman note out Thursday evening:

The ECB’s QE affects bond yields through three interlinked channels. A ‘stock effect’, by which the cumulative amount of long-dated bonds owned, and reinvested, by the central bank shrinks the stock available to private investors and acts to depress the term premium. This effect is amplified in countries, like Germany, that have comparatively lower debt, and little net supply. A ‘flow effect’, as the more regular and predictable is the amount of secondary market purchases conducted by the national central banks, the lower the amount of duration risk dealers are asked to absorb when they underwrite government securities in the primary market. This effect is particularly important in countries where sovereign credit risk is higher. And a ‘forward guidance booster effect’: as long as net central bank purchases are running, investors do not expect the central bank to hike policy rates.

That last one (“forward guidance booster effect”) is a reference to the “well past” language in the ECB statement which effectively rules out a hike until “well” into 2019. Also note the bit there about how the flow effect is particularly important in countries where sovereign credit risk is higher. You can read that as: periphery. And you can also read that as having implications for Spain and Italy if political turmoil persists.

In any event, here’s Goldman breaking the down the taper:

In relation to these channels, the ECB announcements kept the ‘stock’ and ‘forward guidance booster’ effects firmly in place. The ‘flow’ channel is also broadly in line with market expectations. However, despite reinvestments that will start to pick up next year the gross monthly pace of government bonds purchases could decrease from the current level of around €50bn to approximately €25-30bn (including our projected reinvestments – see Exhibit 1). These computations are based on the assumptions that the reduction in the asset purchase program (APP)’s monthly pace will initially be targeted towards government bonds only, leaving purchases under other APP programs (e.g. corporate bonds under CSPP) and supranational bonds unchanged at the current pace. Even assuming alternative (and less drastic) scenarios to the one just presented, the market will have to adjust to a substantially lower pace of activity by the Euro system at a time when bond supply hits a seasonal high.

ECBGS2

That last bit is important. Does it portend trouble especially in the event that euro breakup risk continues to haunt the bloc? Probably not, because you know: “whatever it takes” and all.

But that’s the thing you should keep in mind. “Whatever it takes” doesn’t actually mean “whatever it takes.” Because there are constraints to this program and even if those constraints are dropped (some of them are self-imposed), the problem with “whatever it takes” is that if you do “whatever it takes” now, what happens if you don’t have time to undo “whatever it takes” before the next crisis? That, in many ways, is the fundamental question in an untethered system characterized by rolling booms and busts. It’s about replenishing the ammunition.

Anyway, lest we should get off on a tangent, we’ll end it there.

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