‘After A Decade’: With Central Banks At The Crossroads, A Look Back And Ahead

I’m not a market conspiracy theorist and I’m not fond of people who are.

But one of the most interesting things about the post-crisis monetary policy regime is that for the longest time, pundits and Johnny-come-latelies to the asset management industry attempted to suggest that the inexorable rise in prices for risk assets was somehow not a function of central bank accommodation and that anyone who suggested it might be was a “conspiracy theorist.” That’s not a strawman. I can give you countless examples of people who have accused anyone that cites QE as the proximate cause for the risk rally as pushing the market equivalent of an Area 51 narrative.

If you ask me, the years-long tendency for some market participants to deny reality stemmed in part from an unwillingness to accept the fact that gains logged since 2009 weren’t generally the result of a prudent decision to “be greedy when others are fearful” (to employ that nebulous Buffett quote). Rather, those gains were in large part attributable to G4 central banks deliberately inflating asset prices in an effort to reflate the global economy.

The tendency for folks to deny that (and those denials usually took the form of someone posting a chart of earnings growth overlaid with the S&P and slapping a sarcastic caption on it about how the “fundamentals” are what matters, not quantitative easing), was bizarre for a number of reasons, not the least of which can be expressed as a question: Who cares what’s behind those triple-digit gains on your screen? That is, the gains might be “artificial” in the sense that they aren’t attributable to your own investing acumen, but they are very “real” in the sense that if you decide to realize them, you can spend that money.

Additionally, accommodative policy was designed to help improve the fundamentals, so it’s not exactly a coincidence that fundamentals improved in lockstep with the growth of central bank balance sheets.

Beyond that, there is nothing “conspiratorial” about central bank easing. I’m going to grab some commentary from a previous post of mine in the interest of reminding you that what’s happened since 2009 is the exact opposite of a conspiracy, so if you recognize some of the language in the next couple of paragraphs, that’s because I’ve employed it before.

There has of course been an ongoing, coordinated effort by developed market central banks to inflate the prices of risk assets since the crisis. As I never tire of reminding you, that is the furthest thing from a conspiracy imaginable. It’s how QE works and for anyone who was unfamiliar with the mechanics, it was explained very explicitly in a 2010 Op-Ed in the Washington Post by Ben Bernanke called “What The Fed Did And Why.” That Op-Ed contains this passage:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

If central banks driving stock prices higher and deliberately suppressing corporate borrowing costs is a “conspiracy theory”, well then Ben Bernanke is a “conspiracy theorist”. And if, to take the other side of the argument, this was supposed to be some kind of a closely-held secret that only central bankers knew about, well then Ben Bernanke is the worst co-conspirator in the world. I don’t know about you, but I don’t want to be in a “conspiracy” with a guy who writes an Op-Ed for the Washington Post called “What We Did And Why.”

The point is, “yes” there has been an ongoing effort on the part of central banks to inflate stock prices and catalyze a global hunt for yield that ends up driving everyone down the quality ladder with the effect of leaving everything priced to perfection in fixed income. But “no”, that is not a conspiracy. Again, it’s literally how accommodative policy works.

Now, those policies are being rolled back. The Fed is of course running down the balance sheet (against a deluge of new Treasury supply, by the way, which makes for an absolutely horrible technical in the U.S. debt market), the ECB is set to end asset purchases in December after another short taper in September (the reinvestment flows will persist for some time, but Draghi has been a bit reluctant to discuss the specifics around those reinvestments) and, importantly, the Bank of Japan is considering tweaks to its own policies.

That latter point (about the BoJ), grabbed headlines this week. On Monday, the market responded violently to “rumors” that a policy tweak could be in the cards at the end of this month, and when I say “violently” I mean that 10Y JGB yields jumped as much as 6bps (and that’s a huge move considering the starting point), forcing the bank to step in with a fixed rate operation to cap the rise at 0.10%.

If you’re interested in a lengthy discussion of the BoJ’s quandary (which obviously includes the sensitivity of the yen to perceptions of policy changes), you can find everything you’d ever want to know in “Bond Yields Surge In Japan As BoJ Is Reminded Of Just How Fragile The JGB Market Truly Is“.

Suffice to say that the bank’s cornering of the JGB market (the central bank now owns some 42% of the market) and its yield curve control policy are having a deleterious effect on liquidity, market functioning and also on banks, which have seen their margins squeezed.

(Barclays)

But the potential consequences of the coordinated, global experiment in unprecedented accommodation go well beyond NIM shrinkage. In the same vein, triple-digit returns on benchmark equity indices are just the most visible manifestation of the dynamics created by a decade of easing.

In the latest installment of his popular “Flows And Liquidity” series, JPMorgan’s Nikolaos Panigirtzoglou spends a considerable amount of time documenting the various negative and/or unintended consequences of the post-crisis policy regime. While he uses the recent debate around a possible tweak to BoJ policy to frame the discussion, the points are applicable across the board.

To a lot of market observers (and especially to analysts), none of this is new – nor is it news (with an “s”). But it is timely and when it comes to public awareness regarding the extent to which these policies have rippled across markets creating all manner of distortions (some of which were predictable and some weren’t), the level of familiarity is quite low. Now that these policies are being rolled back, it’s especially important to take stock of things.

Panigirtzoglou begins by noting that “lower bond yields increase pension fund and insurance company deficits putting pressure on pension funds to match assets and liabilities.” When combined with demographic trends, that creates problems.

“Generally, an aging population means that allocations are likely to shift towards relatively safer instruments as the ability to withstand larger drawdowns on capital diminishes as individuals age”, Panigirtzoglou writes, before reminding you that the QE years in Japan and Europe “have seen net issuance of government bonds outside of the public sector balance sheet turn negative, not just in their domestic economies but for the G4 on aggregate [and] these low yields in turn depress the income that investors receive from bonds, inducing them to save even more.”

Moving on, most people seem to have had a come-to-Bernanke moment lately in terms of admitting that a coordinated exit from QE could potentially lead to a reversal of the gains nearly a decade of accommodation has engendered. But Panigirtzoglou suggests you should think ahead in terms of what that might entail for economic expectations:

QE [likely] created asset bubbles by lowering asset yields relative to historical norms, [and] an eventual return to normality could be accompanied by sharp price declines. Perceptions about asset bubbles can thus also increase long term uncertainty. In turn higher uncertainty might prevent economic agents such as businesses from spending.

That, at a time when uncertainty around the future of global trade and commerce is already forcing management teams to reconsider their investment plans. Just ask General Motors, Harley-Davidson, BMW and Daimler to name but a few.

And what about the “zombie” argument? What of “creative destruction”, or the lack thereof? This is a long-running debate and there’s a strong argument to be made that were it not for accommodative policy, a lot of uneconomic U.S. energy production capacity would have been cleaned out a long time ago.

(BofAML)

“By potentially allowing unproductive and inefficient companies to survive, helped by low debt servicing costs, QE could potentially hinder the creative destruction taking place during a normal economic cycle”, Panigirtzoglou says, before again imploring you to think about the longer-term consequences of that:

In principle, QE could thus make economies less efficient or productive over time.

And what about the banks? Think of the “poor” banks! Sure, Wall Street has turned in some impressive results of late (see: Q2 reports from JPMorgan, Morgan Stanley and Goldman), but efforts to mitigate the effects of NIRP notwithstanding (i.e., multi-tiered schemes in Denmark and Switzerland aside), net interest income is invariably dented by negative rates overseas. Here’s Panigirtzoglou:

Even if only a small portion of reserves is subjected to negative rates, banks are not immune to a reduction in net interest margins. This is because banks seem unable or unwilling to pass negative deposit rates to their retail customers, leaving them with few options to offset costs. Indeed, deeply negative policy rates had taken their toll on Danish and Swiss banks’ net interest income (Figure 6). Net interest income as % of assets declined in 2015 for both Danish and Swiss banks following the introduction of very negative policy rates in these countries in January 2015.

JPMorgan goes on to briefly revisit the negative effects (no pun intended) post-crisis policies have had on the functioning of repo and money markets (well-worn territory) before warning that potentially, QE could create political tensions, especially in Japan.

“A longer-term tail risk created by QE is the potential for political frictions, which could escalate in the future especially once QE becomes a negative carry trade for central banks, i.e. when the interest on excess reserves starts rising above the yield they receive on their bond holdings”, Panigirtzoglou cautions.

In other words, if inflation never rises to the BoJ’s target (and it doesn’t seem like it’s going to, no matter how “positive” Kuroda’s attitude is), then the public could begin to ask why the government is effectively perpetuating a negative-carry, debt monetization scheme to no discernible benefit in terms of the real economy.

All of these questions deserve careful attention now that the post-crisis policy regime is being rolled back or, in the case of Japan, at least reconsidered. The list of issues presented above is hardly exhaustive and some of the risk factors mentioned will take years to manifest themselves. It’s entirely possible that by the time some of the unintended consequences of negative rates and QE are readily apparent, it will be difficult to trace their origin, potentially obscuring accommodation’s role in creating distortions and opening the door for the same policies to be rolled out again later.

Speaking of redeploying extraordinary measures (or, in the case of Japan and Europe, doubling and tripling down on them), in the event of an economic downturn, it’s worth mentioning that the burgeoning global currency war may make that more difficult. Recall the following from a recent BNP note:

One cause for concern is that renewed monetary easing by the world’s central banks might rekindle a fear of competitive currency devaluations. Globally, this might be a zero-sum game. For this reason, monetary easing itself poses a risk of destabilising the global financial markets by rekindling memories of currency wars.

JPMorgan’s Panigirtzoglou hints at the same thing, writing that “QE could exacerbate so called ‘currency wars'”.

Whatever the case, we’re at a crossroads, and the bottom line is that on JPMorgan’s projections, duration absorption by central banks is set to go into reverse at the end of 2018.

“After nearly a decade” JPMorgan notes, with a hint of nostalgia – “after a decade.”