When looking at what is arguably the most important chart for risk assets – the net change in liquidity injections/drains from central banks (in addition to net credit creation in China of course) – we have traditionally shown readers some version of the following BofA chart, which demonstrates the Y/Y change in Global QE (Big 3 Central Banks + PBOC)…
… is about to go negative some time in the third quarter of 2018. However, when looked at from a different, more short-term perspective, the central bank party is already over.
As BofA’s Barnaby Martin writes, “while yesterday was all about the pending finale for European (net) asset buying, the bigger story, in fact, has been that global QE has rapidly declined over the last few months. Chart 1 shows global central bank balance sheet growth, on a year-over-year basis, inclusive of China FX reserves.” Note that since Martin has traditionally converted all amounts to USD, the recent surge in the greenback has only accelerated the liquidity decline.
Note how fast the YoY growth in global QE has declined of late. What’s behind such a quick drop? The ECB has been purchasing fewer bonds in ‘18 and China FX reserve growth has cooled (on the other hand, BoJ QE has been relatively stable, and the Fed continues with modest balance sheet run-off).
But what happens if instead of looking at Y/Y growth in central bank balance sheets, one looks instead at the monthly change in QE volumes? Well, as can be clearly seen in the next chart, “the volume of monthly global QE buying has declined significantly over the last two months, commensurate with the USD appreciation.”
This is precisely why any appreciation in the dollar is so destructive to asset values which thrive on liquidity expansion, and wither, or deflate, when liquidity, mostly dollar based, is withdrawn.
As Barnaby adds, since the USD is (still) the world’s reserve currency, movements in the US Dollar impart a tightening/easing bias on global financial conditions, beyond just impacting the US economy (chart 3).
True to form, there has been a reasonable relationship over time between the monthly rate of change of our global QE numbers (in USD terms) and inflows into European IG credit funds. Put another way, slowing global QE means less crowding into risky assets more broadly…which points to less credit inflows (chart 4).
None of the above should come as a surprise. Furthermore, to Martin this shrinkage goes to explain why European credit markets have not been able to fend-off the wave of event risks this year as easily as they were able to in ’17. As he puts it:
“dollar strength has had a draining effect on global QE this year and has resulted in less credit inflows to motivate “buy the dip” behaviour. Last year, Dollar weakness acted in reverse, and thus was supportive for the global QE story.”
There are two direct consequences of this reversal in liquidity: rising market fragility and economic contraction. On the first topic, Martin notes that the lesson so far this year is that without “something else” to take over from monetary support, markets become more susceptible to event risks.
The European credit market has been buffeted by plenty of event risks this year, be it tariff noise, Italy, or even the threat of new issuance. This is a far cry from the market’s robustness of 2017. In fact, Euro spreads have underperformed US spreads, especially in high-yield, in 2018.
In Europe … the hand over from monetary support to “something else” looks less clear to us. Despite Draghi encouraging some pro-growth measures from countries yesterday, the fiscal stance of the Euro Area is set to be roughly neutral over the next few years, according to the IMF. Moreover, as we showed here, the slowdown in bank lending to SMEs of late suggests the potential for a “creditless” recovery in Europe (and note that European bank shares ended lower in Europe yesterday because of the push back in rate hike expectations).
As for the economy, the pass thru is shown in the chart below: whereas the Big 4 central banks have increased their balance sheets anywhere between 100% and 500%, GDP growth has been far more modest, as one would expect as the number are materially different. However, what the chart below shows is not only the relative effectiveness of any one central bank, but also the danger that once the balance sheet begins to shrink, it will be the sovereign GDP that gets hit, whether through conventional credit-led pathways, or simply due to the reversal of the financial economy, which will suffer as soon as global stock markets crash.