Balance sheet reductions and tapering
Since 2008, central bank balance sheets across advanced economies (AEs) have expanded dramatically (e.g. Fed balance sheet went from 6% of GDP in 2007 to around 25% of GDP in 2015 and the ECB balance sheet went from 13% of GDP in 2007 to around 38% currently) and net purchases most recently peaked at roughly $180bn/month in mid-2016. 1 Over the coming 12-18 months, we expect the balance sheet policies of AE central banks to hit a major turning point: we think net asset purchases will fall from roughly $120bn/month currently to around zero by mid to late 2018, as the Fed reduces its balance sheet and the ECB, BoJ and Riksbank reduce their net asset purchases.
We have previously noted (here and here) that the changing balance sheet policies of central banks will have the effect of increasing the net supply of a range of assets to the private sector. Our colleagues in credit strategy have been arguing that this shift can be a big deal for markets as various risk asset returns have correlated strongly with measures of central bank purchases in recent years. They find correlation of 3-month changes in global central bank balance sheets with various 3-month risk asset returns. Here we look over the entire 6-18 month duration of each global tapering episode and investigate the ultimate direction of returns. Our rates strategists have also estimated that the Fed’s balance sheet reduction is worth a modest +5bp to +15bp in coming months.
Even though there has not been a “global post-QE” world before, there have been temporary slowdowns in the flows of net asset purchases in aggregate and reductions in balance sheet size for specific economies. From these episodes we may be able to glean some insight as to what we can expect as central bank stimulus through balance sheet expansion is tapered and later reversed. To that end this note considers several relevant precedents of central bank balance sheet reductions and tapers of net asset purchases, including the reductions in aggregate global central bank net asset purchases (in 2009-10, 2011, 2013/14 and since mid-2016), the reductions of the BoJ and ECB balance sheets in 2006 and 2013-14, respectively, the purchases tapering episodes for the BoE (2010, 2012) and Fed (2009, 2011, 2014) as well as the (temporary) run-down of the Fed’s MBS portfolio (2010-11) and the ECB’s Covered Bonds portfolio (in 2010-11 and again in 2012-14).
Circumstances and approaches vary widely between these episodes. It is therefore not surprising that the evidence of the correlation between these asset price changes and balance sheet policy changes is rather mixed. That being said, we note:
1. Sometimes the effects are both large and spillover to other markets. During the “taper tantrum” (which preceded the tapering of QE3 in the US) 10y Treasury yields nearly doubled in four months (1.7% in May to 3.0% in Aug-13) dominated by a 1.4pp increase in the term premium (as estimated by the NY Fed). The euro area average sovereign 10y yield 2 rose from 2.6% to 3.2% in the same period and UK 10y gilts yields from 1.7% to 2.9%.
2. Core sovereign yields have often fallen during (global or local) tapering. US and euro area 10y yields fell over the period of all the past global tapering periods. They rose initially in 2016 but have been falling throughout 2017. In the 2009-10 global tapering German 10y Bund yields fell from around 3.5% to around 2.5% and in the global 2011 tapering they fell from 3.2% to 1.9%. Through the tapering period Jan-Oct 2014 in the US, 10y Treasury yields fell from 3.0% to 2.4% (and continued to fall after net asset purchases stopped).
3. Equity markets mainly performed well during and after global tapering of purchases. During the 2009-10 global tapering the MSCI World rose 28% in 16 months and in the UK, the FTSE 100 and 250 indices had positive returns in the 3 months following each of the three initial rounds of Fed QE. However, the evidence is mixed and e.g. the MSCI World fell 21% in 6 months during the global tapering in 2011 as the euro area sovereign crisis escalated.
Still the evidence suggest that financial markets did not react consistently or uniformly to the end or reversal of net asset purchases by central banks, nor can we attribute the asset market developments at the time uniquely to central bank actions; e.g. market-based measures of inflation expectations (5y5y breakevens) fell after the end of QE2 and QE3 in the US but increased after QE1 in 2009. The euro area 5y5y inflation swaps fell from 2.4% to 1.6% over the repayment window of the LTROs in 2013-14, but UK inflation breakevens rose in the three months after the end of QE1 (3.6% to 3.8%) and QE3 (3.0% to 3.5%). Indeed, in most cases and for most asset markets, the effects of CB purchases are difficult to trace and there were plenty of other relevant developments at the time that may have been more significant for asset prices than the central bank purchases.
Given my view that if tapering is to proceed this year then it will have to do so directly into a deflationary gale blowing from oil, then I think we can say confidently that bond bears are going to be sorely disappointed. That means equities could also benefit.
Indeed, debt and equity could be lifted towards a great cyclical blow-off with a cratering yield curve and soaring stocks.
The key is probably Chinese growth. If it is still firm and markets conclude it’ll hold up through 2018 then it may well be party time. If not, and DM central banks taper into the oil deflation and wider commodities crater, then growth fears will overwhelm risk appetite and it’ll be back to the Mining GFC with a bullet.