Why This Wind Down Is Different.

On of the the key questions headed into 2018 is obviously how markets will react to more Fed hikes and the ECB taper.

The consensus is that still subdued inflation will give central banks just the excuse they need to keep the forward guidance dovish enough to ensure there’s not a disorderly unwind of the bond trade. Policymakers are engaged in a 24-7/365 effort to keep the risk of such an unwind infinitesimal. That’s a tightrope walk that requires constant communication with market participants who must be kept “in the loop” at all times.

One unknown is how the market will react when the supply/demand dynamics shift. Remember, part and parcel of the entire post-crisis policy response is the distortion of supply and demand. Central banks have engineered a scarcity and that scarcity drives up prices, creates an insatiable hunt for yield, and pushes investors out the risk curve. One wonders what happens when that scarcity becomes less acute.

“The ECB has driven asset prices in € fixed income up to a level where every other major investor type has become a net seller [and] we think it is a brave assumption to presume that the selling will just magically stop, as the ECB scales back (from €780bn this year to €270-350bn next year),” Citi writes, in their European credit outlook, before expressing similar reservations about the U.S. as follows: “Similarly in the US, it is far from certain that the incremental private demand, domestic or foreign, required to soak up the Fed’s asset sales will seamlessly emerge.”

Well, Deutsche Bank has some thoughts on that as well. If you look at the following chart, you can see that this won’t be the first time in the post-crisis era that we’ve been through a CB balance sheet rundown:


But this time could be different. And here’s why, via DB:

In 2018 a reduction of purchases across the globe could be occurring at a time when there is a move to increase government spending even if this isn’t yet showing up in the forecasts. The US tax plans haven’t been finalized as we go to print but an unfunded tax cut is our base case which will add to the deficit and eventually to treasury issuance. In the UK the budget – seen just before we went to print – included some loosening of the fiscal purse, as the current administration deal with Brexit risks and a population tired of austerity. Even in Germany, the recent election uncertainty and eventual coalition could include some fiscal stimulus. So we think the tide is turning away from ultra loose monetary and relatively tight fiscal even if the official fiscal forecasts from most commentators are yet to include much in the way of easing across the globe.

Now think about that in the context of what we and others have said about looser fiscal policy (i.e. deficit spending) and a dismantling of the post-crisis regulatory regime. Those are inflationary outcomes that could end up putting central banks behind the curve.

In any event, DB goes on to note that “the Fed’s purchases of Treasuries have never exceeded its net supply,” and although “the BoJ has exceeded domestic net supply in the last few years, this ratio has recently stabilized at around three times.”


The picture is far different in Europe where ECB PSPP has outrun net issuance by a whopping seven times:


The upshot (in case it’s not clear) is this:

In Europe we could see government bond QE go from seven times net issuance in Q3 2017 to more in line with it by the end of 2018. As the realisation mounts that ECB QE withdrawal is much more significant in relative terms to that seen in the US in 2014 then fixed income markets could become more vulnerable which may in turn create more volatility and more difficult conditions for credit spreads.

Coming full circle to what we said above about inflation, DB asks one of the only questions that matters: “Could the flow of global QE be declining at a time of looser fiscal policy and inflation that no longer consistently misses on the downside?”

To that we would add: could that coincide with significant rollbacks in regulation?

If the answer to those questions is “yes,” well then follow the red line in the chart below…



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