If ‘It Sounds, Looks And Smells Like Debt Monetization’, It’s A Duck.

Even as risk assets remain broadly supported by ostensibly upbeat trade headlines and the prospect of another coordinated reflation effort from global central banks, concerns about the capacity of monetary policy to respond to any meaningful downturn continue to pervade the market narrative.

Indeed, that’s the irony of risk assets rallying on the “epic” dovish pivot from developed market central banks and the credit creation “binge” in China – this nascent reflation effort has added a sense of urgency to questions about monetary policy being exhausted and heightened worries about diminishing returns on credit growth in China.

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Those questions and concerns speak to the contention that reflationary themes and the YTD risk asset rally are merely “for rent” – to quote Nomura’s Charlie McElligott – while everyone waits to see how deep an assumed downturn will be and whether policymakers are as hamstrung in their capacity to counter it as current levels of policy rates and still-bloated balance sheets would appear to suggest.

“The ‘end-of-cycle’ investor skepticism mentality too remains firmly in place, with most voicing a desire to only ‘rent’ these themes against a rapidly-aging business cycle which is being propped up by central bank dovish spasms and capitulation”, Charlie wrote Monday.

Whatever the case, one thing that’s becoming clear is that a full unwind of QE is not only unlikely, but in fact impossible.

Irrespective of where you stand on the idea that the mechanical impact of QT is large enough to dent risk assets, there is little question that the combination of that mechanical impact (whatever it is) and the psychological impact of “reverse QE” are together enough to throw markets for a loop. The Q4 2018 experience made that abundantly clear.

And while some contend that the psychological impact is far greater than the mechanical impact, others take a kind of anecdotal approach to things. “After spending seven years telling us that the Fed balance sheet expansion was equivalent to rate cuts, we are now told that the opposite — balance sheet contraction is like ‘watching paint dry'”, BofAML’s Ajay Singh Kapur sarcastically chided, in a note out earlier this month, adding that benign takes on Fed QT appear to emanate “from heroic assumptions of a rise in the US money multiplier, even a potential doubling in three years.”

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Kapur’s take wasn’t all anecdotes – far from it. In fact, he explicitly accused central banks of either mistaking an equivalence relation for a theory or else of being “oblivious” to economic reality. He also noted that “the correlation of EM equities with the major central banks balance sheets is 0.94 in the past three years [and] world equities have a similar correlation of 0.94 since 2009”. [Note that the following two charts were almost always derided with cat calls of “correlation doesn’t equal causation!” prior to Q4 of last year. Now, the financial Twitter-verse habitually points to those charts when explaining the selloff]

(BofAML)

In any case, one important thing to keep track of during this ongoing debate about what comes next for central banks is the fact that if QE cannot be unwound, then we’re just monetizing debt at this juncture. That’s something everyone has generally tried to avoid admitting since the crisis, but it just is what it is (so to speak).

Well, in a note dated Monday, SocGen talks at length about this. To wit, from a piece aptly entitled “The Great Retreat by central banks”:

The central banks that embarked on QE, i.e. the US Fed, the ECB, the BoJ and the BoE to name the main ones, originally intended QE to be a temporary tool that could be unwound when the worst of the Great Financial Crisis had past. But it is looking increasingly likely that much, and perhaps all of the debt that the CBs loaded onto their balance sheets will stay there. In other words, it is looking increasingly likely that sizeable chunks of the national debts of a host of countries have been monetised, and most likely permanently.

Right. So it’s a Ponzi scheme – basically. Which is something we all knew ten years ago.

The immediate implications of this are as follows, from the same note:

1. Fiscal authorities benefit from the fact that practically all central banks transfer a large part of their profits to the state coffers. Hence, most if not all the interest that states pay on their debt to their CB comes flowing right back to the fiscal authorities. This raises the amount of debt a state can carry sustainably, regardless of the level of interest rates.
2. The level of bond yields would be permanently lower than they would otherwise be, also raising the level of debt that can be sustained.

Theoretically, that can’t work forever. It’s an inherently absurd charade that should, eventually, lead to inflation. Thanks to liquidity remaining parked in commercial banks’ reserve accounts, that hasn’t happened yet, but unless everything we learned in business school (those of us who actually went to business school, that is) is wrong, it will eventually.

Or maybe not. Who knows. What we do know is that the above is prima facie silly, but so is the entire system, which brings us right back to questions about whether we’ve all been thinking about this wrong. If the system is a man-made construct not subject to any natural restrictions, then by definition any constraints are self-imposed. That then raises uncomfortable questions about what it is that’s really “silly” – is it debt monetization and other ostensibly “insane” experiments, or is it the idea that we are pretending like rules we made up are actual laws of nature?

Whatever, right? Something to kick around.

Finally, here are SocGen’s updated outlooks for major global central banks in light of recent events:

US Federal Reserve: No further rate hike in this cycle. The next move will be a rate cut. The Fed soon starts reinvesting the proceeds from maturing Treasury paper (the Fed becomes a net buyer of USTs in the tune of $200bn) but stay net seller of MBS.

ECB: Policy normalisation delayed, we expect the first deposit rate hike in December 2019 (+15bp), the era of negative rates ends in March 2020 (+25bp). Any balance sheet shrinkage will be delayed until 2021. The ECB will offer additional long term (2Y or more) refinancing operations.

Bank of Japan: 0% target for 10-year JGBs maintained until mid-2021. The BoJ may consider additional easing.

PBoC: No change in our policy-easing expectations: 100bp cut of the reserve requirement ratio per quarter. A stable CNY exchange rate creates scope for additional easing.

Bank of England: Monetary policy is hostage to the outcome of Brexit. Damage to confidence delays the rate hikes to November 2019.