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The global shift away from easy money is poised to accelerate as a pandemic bond-buying blitz by central banks swings into reverse, threatening another shock to the world’s economies and financial markets.
Bloomberg Economics estimates that policy makers in the Group of Seven countries will shrink their balance sheets by about US$410 billion in the remainder of 2022. It’s a stark turnaround from last year, when they added US$2.8 trillion — taking the total expansion to more than US$8 trillion since COVID-19 arrived.
That wave of monetary support helped prop up economies and asset prices through a pandemic slump. Central banks are pulling it back — belatedly, in the view of some critics — as inflation soars to multi-decade highs. The dual impact of shrinking balance sheets and higher interest rates adds up to an unprecedented challenge for a global economy already hit by Russia’s invasion of Ukraine and China’s new COVID lockdowns.
Unlike previous tightening cycles when the U.S. Federal Reserve was alone in shrinking its balance sheet, this time others are expected to do likewise.
Their new policy, known as quantitative tightening — the opposite of the quantitative easing that central banks turned to during the pandemic and the Great Recession — will likely send borrowing costs higher and dry up liquidity.
Already, rising bond yields, falling share prices and the stronger U.S. dollar are tightening financial conditions — even before the Fed’s push to raise interest rates gets into full swing.
“This is a major financial shock for the world,” said Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis SA, who previously worked for the European Central Bank and International Monetary Fund. “You are already seeing the consequences of tapering in reduced dollar liquidity and dollar appreciation.”
The Fed is expected to raise rates by 50 basis points at its May 3 to 4 policy meeting and several times thereafter, with traders seeing about 250 basis points of tightening between now and year’s end. Officials are also expected to start trimming the balance sheet at a maximum pace of US$95 billion a month, a quicker shift than most envisaged at the start of the year.
The U.S. central bank will achieve this by letting its holdings of government bonds and mortgage-backed securities mature, rather than actively selling the assets it bought. Policy makers have left open the option that they might, at a later stage, sell mortgage bonds and return to an all-Treasuries portfolio.
In 2013, the Fed’s balance-sheet plans caught investors by surprise and triggered an episode of financial turmoil that became known as the “taper tantrum.” This time around, the policy has been well telegraphed, in the U.S. and elsewhere. Asset managers have had time to price in the effects, which should make a wrenching shock on the markets less likely.
FIRST IN HISTORY
So far, the Fed’s proposed runoff has led investors to demand a cushion for risks of owning long-term U.S. Treasuries. Term premium — the extra compensation that investors require to own longer-maturity debt rather than continually rolling over shorter-dated obligations — has been on the rise.
Fed officials have said that QE helped depress yields by lowering term premium, providing a cushion for the economy during the 2020 recession. Investors expect QT to do the reverse.
The Fed’s pace of balance sheet unwind is expected to be roughly twice as fast as in 2017, when it last ran down its holdings.
The magnitude of that contraction and its expected trajectory are a first in the history of monetary policies, according to Gavekal Research Ltd. fund manager Didier Darcet.
Others are moving in the same direction:
- The European Central Bank has signaled it will end QE in the third quarter, a timeline that is complicated by the spillover from war in Ukraine.
- The Bank of England has already started to shrink its balance sheet by ending gilt reinvestments in February. It is expected to hike rates again in May, bringing the key rate to the threshold where policy makers will weigh active sales from their asset portfolio.
- The Bank of Canada’s passive roll-off of its balance sheet — opting not to buy new bonds when the ones it owns mature — is expected to see its holdings of government debt shrink by 40 per cent over the next two years.
The Bank of Japan is the standout and remains wedded to asset purchases — it had to scale them up in recent weeks to defend its policy of controlling bond yields. The yen has weakened to the lowest in 20 years in the process.
China, which avoided QE through the crisis, has switched to stimulus mode with targeted measures aimed at providing funding for smaller businesses, as it fights to contain the country’s worst COVID outbreak since 2020. Chinese leaders on Friday promised to boost stimulus to spur growth.
Investors fear the unknown as liquidity is drained from bond markets that have been flooded with central-bank money over a period that stretches back to the 2008 financial crisis. Markets like housing and crypto currencies that soared in the easy-money years will face a test as liquidity tightens.
“With all this central bank tightening coming into a slowdown already, it will really be all about if the central banks will tip us into recession,” said Kathy Jones, chief fixed-income strategist at Charles Schwab & Co., which manages over US$7 trillion in total assets.
Some are paring back on risk assets in anticipation.
Robeco Institutional Asset Management has bought short-dated bonds and cut back on its holdings of high yields, credits, and emerging market hard-currency bonds as it expects the economy to slow down or even head into a recession this year.
Wealth manager Brewin Dolphin Ltd. is becoming more defensive as it looks to reduce equity holdings when there’s a rally.
Citigroup strategist Matt King said liquidity flows are far more important, and have better correlation with equities, than real yields. He estimates that every US$1 trillion of QT will equate to a decline of roughly 10 per cent in stocks over the next 12 months or so.
'WATCHING PAINT DRY'?
To Chris Iggo, the chief investment officer at Axa Investment Managers, it’s a good time to buy bonds as a safety hedge in case stocks react badly to QT and higher interest rates.
“Equities tend to do worse when the economy really tanks, and earnings are cut. That is preceded by higher rates,” said Iggo. “On that timeline we are not there yet. But adding fixed income slowly as yields go higher will eventually give a more efficient hedge in a multi-asset portfolio when and if equity returns do turn more negative.”
Central bankers have argued that shrinking their balance sheets by allowing bonds to roll off, rather than abruptly selling them, shouldn’t be too disruptive. The process was once described by then-Fed chair and current U.S. Treasury Secretary Janet Yellen as akin to “watching paint dry.”
Still, the combination of QT, rising short-term rates, a strong dollar, higher commodity prices and U.S. fiscal contraction presents the U.S. and world with a major headwind, said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments.
“That’s a lot to deal with for the economy,” Tannuzzo said. “We don’t have to have a recession to say growth is going to be pretty sluggish at the end of the year.”