Don’t Kid Yourself: ‘No One Knows How This Will Play Out’

When it comes to the contention that somehow, markets are going to be able to come away from the unwind of central bank balance sheets unscathed, you can color me incredulous.

And here’s the thing, I’m not the guy telling you that the world is going to end if the ECB calls time on APP in September (as opposed to say, extending it for three more months, which was some folks’ base case until a couple of weeks ago when the rhetoric started to shift as the econ continued to surprise to the upside).

I’m also not the guy telling you that markets are going to collapse if Kuroda ends up following in the Fed and the ECB’s footsteps amid what looks like the beginning of a shift in the deflationary mindset in Japan (and no, that’s not some kind of jab at Albert Edwards, it’s just to say that I’m inclined to think Kuroda has a ways to go before anyone is going to describe him as any semblance of “hawkish”).


Finally, I’m not the guy telling you that eventually, the Fed’s efforts to shrink the balance sheet are going to result in a dramatic rise in bond vol. (in fact, I recently gave you an argument as to why the MBS rundown might not be that big of a deal).

All I’m saying is that there are very real reasons to believe that this time is indeed “different” when it comes to the backdrop against which reduced CB flow will play out. The bottom line is that you can’t reasonably expect asset prices not to respond when the supply/demand equation changes and that’s what’s about to happen.

Everyone has seen the chart by now. And by “the chart”, I mean this one or some variation thereof:


If it’s the flow that matters (as opposed to the “stock”), well then that’s a problem unless of course EM takes up enough of the slack created by DM normalization to cushion the blow.

But – and this is the point here – that doesn’t tell the whole story. That’s just the demand side of the equation. We’ve seen the flow abate before and there was no lasting damage, but as Deutsche Bank’s Jim Reid writes, there’s a “key difference” between now and previous episodes of declining CB flow. To wit:

One key difference is that a few years ago, tapering by the Fed was largely consistent with the reduction in government issuance. In fact, treasury purchases never exceeded net issuance in any 12-month period. In Europe and Japan, QE has been proportionately far larger. In 2017, ECB and Bank of Japan government bond purchases peaked at seven and three times larger than their respective net issuance respectively. Those multiples are unsustainable, not just because central banks will be looking to wind-down their balance sheets but governments are also poised to increase spending and that presents downside risk. The proposed unfunded tax plan in the US is an example, while the recent UK budget included some loosening of the fiscal purses. In Germany, a new coalition could include some fiscal spending.

This is such an obvious problem (or if it’s not a problem, it’s at least an “issue”) that it’s remarkable it doesn’t get more attention. To be sure, that’s not Jim Reid’s fault. He’s been talking about this for quite some time and indeed, he made the same point in a note out last year. This time around, the analysis is delightfully succinct. Here’s a bit more:

To the extent that tapering will coincide with a move towards increased government spending globally, then the ratio of rolling central bank asset purchases versus net issuance will surely fall after peaking in 2017, affecting technicals for bonds. Therefore, 2018 has the potential to be a substantial tipping point in the supply/demand dynamic. This is especially the case in Europe. As the realisation mounts that ECB’s quantitative easing withdrawal is much more significant in relative terms to that seen in the US in 2014-15, then fixed income markets could become more vulnerable and volatility spikes should become a much more common occurrence.


Again, nothing there says this has to end badly – and I hope regular readers know that what separates me from other cynical market bloggers is that I’m always at least half joking when I make dire predictions and despite outward appearances, I don’t take myself too seriously. But what it does quite clearly suggest is that the dynamic is different this time.

So what you have is a different dynamic on top of an unprecedented experiment in accommodation. That is, “this time is different” in general because we’ve never seen anything like this in terms of the post-crisis policy response and “this time is different” specifically in the 2018 context due to a notable shift on the supply side of the equation.

I’ll leave you with one last quote from Reid which speaks more to the general uncertainty surrounding the unwind than it does specifically to the 2018 scenario:

In short, just as no one really understood how quantitative easing would work during the buildup, no one knows how the unwind will play out.


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