Historic central bank leak calls ‘buying the dip’ into question
The odds that investors will avoid a rare year of equity declines are diminishing as central banks prepare to undertake the biggest cash drain in history.
The US Federal Reserve, the European Central Bank and the Bank of England are signaling a reversal in emergency monetary parameters in the event of a pandemic. The combination of higher interest rates, a halt to bond purchases and a possible reduction in their bloated balance sheets will sap billions of dollars of liquidity from global markets over the next 12 months and beyond. .
How well historically high stock prices can absorb this shock is the investment question of the year.
Morgan Stanley analysts estimate that G4 central banks will drain $2.2 trillion of liquidity from the global financial system over 12 months, in what they called “the largest quantitative tightening in history.”
They estimate that the G4 central bank‘s combined balance sheet will peak in May and that the $2.2 trillion cut will be more than four times the $500 billion drained in the last “quantitative tightening” attempt in 2018.
It is worth noting. Global stocks fell 20% from peak to trough that year as the Fed raised rates and began shrinking its balance sheet. The eventual toll on the markets has forced the Fed to put these particular policy tools back in their box.
Could a 20% drop – technically ushering in a bear market – be on the cards this year? With the Fed under political pressure to control inflation and play politics for Main Street rather than Wall Street, and with BoE and even ECB tightening now on the table, this is a credible prospect.
Citi strategist Matt King notes that while the relationship between central bank liquidity and financial markets in the months ahead is as strong as it has been over the past decade, stocks and other markets are vulnerable.
G4 central banks expanded their balance sheets by $8 trillion in 2020 and another $3 trillion last year. Their overall balance sheet is over $26 trillion.
It was jet fuel for last year’s equity boom, King says, which generated total returns of nearly 30% for the S&P 500. If it’s the relative change rather than the absolute level of liquidity that drives markets, removing even a fraction of post-pandemic support could be huge.
“It’s not a global arms race in terms of tightening up, but there is a nexus between their policies, which collectively creates a global movement. And that counts for risky assets,” King says.
“QE produced an ‘all rally’. At a minimum, this liquidity no longer drives everything up. So, logically, you should worry about the risk of a ‘total sale’,” he adds.
Others argue that the greatest impact on asset prices of quantitative easing or tightening is felt on the announcement, as investors react quickly to reassess expected levels of interest rates, earnings companies and valuations.
Admittedly, the minutes of the Fed’s December policy meeting released on Jan. 5 detailing the QT discussion dealt a major blow to market sentiment. Wall Street and global equities fell about 10% before managing to halve those losses.
But if Citi’s King is correct that QE or QT won’t really hit the markets until the process begins and liquidity is actually added or removed, risky assets will experience a hotter period over the next two years.
Bank of America analysts estimate that the Fed’s balance sheet will shrink to 31% of GDP by the end of this year from 36% currently, while that of the ECB will shrink to 56% of GDP from 69% currently.
These are among the boldest predictions, but if correct, it could represent cash losses of up to $1.5 trillion and $2 trillion, respectively. These are huge sums, perhaps too large for the markets.
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