With just months left until the global central bank liqiudity supernova finally ends, and turns into a drain of cash …
… Bank of America has published its latest Quantitative Tightening analysis, writing that whereas Quantitative easing was mostly characterized as an environment with too much money chasing too few bonds, lower interest rates, tighter credit spreads and volatility was suppressed, “there is no doubt that quantitative tightening (QT) at times will lead to the opposite – i.e. higher interest rates, wider credit spreads and very volatile market conditions (Figure 1).”
However, the reason why all hell has not yet broken loose, is that we are still in this “intermediate phase” – i.e. on the road from QE to QT – where things remain orderly although as the BofA credit team writes, “technicals of the high grade credit market have weakened notably this year due to less demand (Figure 2).
Hence, as we slowly make the transition from QE to QT, we have already witnessed higher interest rates, wider credit spreads (Figure 3) and more volatility (Figure 4). And this is just the beginning.
Of course, it will hardly come as a surprise to anyone paying attention that the reason why the markets haven’t i mploded yet, and the reason why we are not yet experiencing the full effect of QT is that foreign central banks – the ECB and BOJ in particular – are still providing tremendous monetary policy accommodation via QE and negative interest rates (Figure 5), even if these two risk-boosting stimuli are gradually fading.
This push-pull equilibrium as defined last week by Jeff Gundlach, allows the system to persist in this unstable state indefinitely, because every time US yields rose too much due to QT and rate hikes, there would be large foreign inflows. “Hence, US yields would not increase too much and fixed income volatility remains moderate” according to BofA’s Hans Mikkelsen. Preventing an out of control collapse in risk assets, whereas last week the ECB announced the end to QE, it also came out unexpectedly dovish by returning explicit calendar guidance and promising continued negative interest rates (NIRP) for a long period of time (Figure 6).
At the end of the day, the dovishness prevailed, sending the EUR plunging, as NIRP in the Eurozone works much like QE, as it encourages companies and individuals to take risk way out the maturity curve or down in quality.
But while NIRP controls the short end doesn’t the ECB needs QE to infludence the back end of the curve? Not really: with persistent negative interest rates, European investors are forced to either take a lot of interest risk or credit risk to earn even a small positive yield of 0.50% for example (Figure 9). That asserts bull flattening pressure on both rates and quality curves.
And this is where things get interesting, or as BofA notes, “we have not seen this movie before”, because as Mikkelsen writes, “while QT in itself is a rare occurrence we have never been in an environment of QT with a backdrop of major foreign QE/NIRP. Given the clear failure of the ECB and BOJ to meet their policy goals of near 2% inflation (Figure 8) the road from QE to QT may be very long – certainly years.”
What does all this mean in terms of practical credit trades? Here BofA is growing skeptical that a bullish credit trade will be appropriate as we continue to shift away from QE and closer to full-blown QT.
While we consider high grade credit spreads this year range bound – and in fact presently are at the wide end of the range due to supply pressures that will ease and Italian risks we will increasingly decouple from (although they remain severe a bit further out) – we continue to believe that the end to ECB QE means moderately wider spreads next year and in 2020.
This is because the ECB presently buys about $400bn of bonds annually, which pushes investors into the US market. Without that we get less inflow from Europe and technicals deteriorate further. Partially offsetting this will be less supply as the relative after-tax cost of debt has risen due to higher interest rates and a lower corporate rate.
The only question is when will the algos, buybacks and occasional central bank intervention in stocks (mostly the SNB and BOJ) that set the daily trading mood, finally concede what is coming, and let fundamentals and market logic finally reassert themselves.
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