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Column: Central Bank Strength Siphons Global Liquidity: Mike Dolan

By on June 17, 2022 0

A symphony of light made up of bars, lines and circles in blue and yellow, the colors of the European Union, illuminates the south facade of the headquarters of the European Central Bank (ECB) in Frankfurt, Germany, on December 30, 2021 .REUTERS/Wolfgang Rattay/File Photo

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LONDON, June 17 (Reuters) – Coordinated or not ahead of this month’s G7 summit, global central banks are accelerating interest rate hikes but are also actively draining the huge pool of liquidity circulating in markets. world markets and stimulate currencies to counteract imported inflation.

You don’t have to be a strict monetarist or obsessed with liquidity to see how the magnitude of this will affect stocks and bonds for the rest of the year at least.

For many who focus on the direct impact of global liquidity on asset prices, the process has already been underway since late last year and was the driving force behind the 20-30% drop in main stock indexes since December. (.SPX)(.IXIC), (.MIWD00000PUS)

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Worryingly for investors, it may only be halfway through and the aggressive tightening unveiled this week shows little concern among policymakers at this time.

This week’s interest rate hikes by the US Federal Reserve, Bank of England and Swiss National Bank show a newfound resolve to ride out decades of high inflation as quickly as possible as unemployment rates are close to historic lows and labor markets remain tight.

The European Central Bank has wondered how to curb soaring euro sovereign risk premia as it prepares to raise rates next month for the first time in more than a decade. But the ‘anti-fragmentation’ backstop deal was seen as a quid pro quo for bigger policy rate hikes and markets are now pricing in nearly 2 percentage points of hikes by the end of the year. .

The Fed’s outrageous 75 basis point rate hike was its biggest move in 28 years, with markets now expecting its key rate to more than double from the new target range of 1.50 to 1.75% within a year. Even grappling with a much weaker economy, the Bank of England also expects to nearly double rates to over 2% from here.

The SNB’s shock half-point rate hike on Thursday threw another log on the fire, leaving a lone Bank of Japan the only major player to keep short- and long-term borrowing rates on hold. decrease.

Technical recessions may now be an inevitable price to pay. Some argue that allowing inflation to stay so high may trigger one anyway by cutting real earnings and corporate margins hard.

But higher central bank borrowing rates are only part of the story and the big unwinding of central bank balance sheets is arguably having a much more direct impact on global markets.

Fed balance sheet, bank reserves and stock markets
Central Bank interest rate hike

SECRETLY DRAINING

According to liquidity specialists CrossBorderCapital, the annual percentage change in central bank liquidity has already collapsed and is contracting from peak annual expansion rates of around 40% last year.

In a note released just ahead of this week’s barrage of official rate hikes, he pointed out that this contraction was underway ahead of the start this month of Fed “quantitative tightening” (QT) or the equivalent of the ECB next month – as messy as the latter may be in light of yet another “fragmentation” breaker.

And he expected an annual contraction of up to 10% to persist for the next two years.

The Fed’s contribution to the legendary punch bowl this year is a good example.

Even though its overall balance sheet is well over $8 trillion on the eve of QT, commercial bank reserves held at the Fed – a flip side of balance sheet assets and where real liquidity in global markets comes from – have fallen by nearly $1 trillion since December as the US Treasury account at the Fed filled.

And that’s before roughly $1 trillion to $2 trillion in overall balance sheet reduction collapses over the next 18 months.

Claiming that the Fed has “secretly reduced liquidity injections” this year, CrossBorderCapital describes how the confluence of reduced Treasury bill sales and Fed rate hikes is drawing more and more of that money into operations. Fed reverse buybacks – currently amounting to over $2 trillion a night.

This further reduces the “effective balance sheet of the Fed” and this could now be halved by 2025 due to the combination of outright balance sheet decline and the appeal of reverse repos.

“A rising tide may float many boats, but a tsunami of monetary tightening is unquestionably sinking asset markets,” he concludes.

Although it may seem like arcane accounting, the change in these liquidity measures is oddly in line with market prices.

Beyond the Fed, the picture of the ECB may seem more complicated. But the BoE’s balance sheet reduction is also due and the SNB’s surprise rate hike sees it adopt a strong Swiss franc to dampen imported inflation and likely stop its hoarding of global stocks and bonds in its linked balance sheet. at change.

Moreover, the Fed’s aggressive tightening stance promises even more dollar strength to come, forcing other central banks into similar tightening lest they exaggerate their inflation pictures with ever-higher energy and food imports in the pipeline. dollars as well as tighter borrowing conditions for emerging markets.

“The past decade has been a race to the bottom in global currency wars, with lackluster inflation dynamics, but the mood music has now changed,” said Charles Hepworth, chief investment officer at GAM Investments.

Central bank balance sheets

The author is Finance and Markets Editor at Reuters News. All opinions expressed here are his own.

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by Mike Dolan, Twitter: @ReutersMikeD; edited by David Evans

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and freedom from bias by principles of trust.