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The central bank jigsaw

Since the financial crisis, central banks around the world have taken center stage in the fight against a global depression. But the emergency financial measures of yesteryear have become the status quo as markets around the globe continue to ride an unprecedented updraft of supportive monetary policy. We focus below on the driver behind all of this: liquidity.

Unraveling the flows

Central banks have effectively been running a relay race since the GFC to keep the liquidity torch burning and to ensure some semblance of economic growth or at least asset price inflation. The US was first in with its QE programme, followed by the UK, the BOJ, and the ECB. Each bank, in turn, has printed money and bought up huge swathes of assets, driving flows in global markets and across borders.

Crossborder Capital provides essential research focusing on the direction and rate of change of those flows, helping investors to unravel where liquidity is going and how to benefit from it:

Latest liquidity and capital flow data reinforce 2017 themes of a more robust China and an increasingly fragile US dollar. Admittedly, the moderate drop in September 2017 GLI™ to 43.4 (‘normal’ range 0–100) is largely down to reverses of QE by major Central Banks.

However, what this disguises is an on-going shift of capital from US to non-US markets, which is undermining the US dollar. Over the past three years, a whopping near US$3 trillion quit the Eurozone and China, the latter as flight capital and the former pushed out by the ECB’s ultra-loose monetary stance. The bulk of this capital flowed into US assets. Now flows are starting to reverse.

The current liquidity being created by the ECB is still high at EUR60bn a month; but with expectations of a reduction coming soon, euros that have gone abroad in search of positive interest rates may start to flock back to the Eurozone. Growth rates have been impressive ex-US versus recent history (e.g. Europe), whilst the market’s insistence on pricing a terminal rate on the US at around 2% means that it has been hard for the US to move the dial, whilst other regions have been surprising to the upside – hence the USD weakness.

European Central Bank officials are considering cutting their monthly bond buying by at least half starting in January and keeping their program active for at least nine months, according to officials familiar with the debate.

Reducing quantitative easing to 30 billion euros ($36 billion) a month from the current pace of 60 billion euros is a feasible option, said the officials, who asked not to be identified because the deliberations are private. – Bloomberg

Therefore, whilst the total size of the ECB balance sheet will continue to expand, the declining rate of change means that additions to global liquidity will drop, providing less new money supply to chase scarce assets. With the ECB’s reducing purchases and potentially ending them altogether in nine months and the Fed set to start tapering this quarter, global liquidity conditions look set to decline.

The wild card remains the sporadic injections of liquidity by the PBOC.

Enter the Dragon

The tightening of global liquidity is likely to cause a cooldown in economic activity. The Chinese cannot afford for this to happen, especially just ahead of the 19th Communist Party Congress, so stimulus is the order of the day. Chinese conditions have been improving since 2016:

Heat Map: Total Liquidity index

(Red colour gives warning of low liquidity, ‘Normal’ range 0-100)

Source: CrossBorder Capital

Notice in the diagram above that the Eurozone has seen incredibly accommodative policy, which peaked at ~93.6/100 – which pretty much coincided with the bottom in the EUR/USD rate. These flows are highly determinant of future rates and asset price expectations. The mechanism was succinctly explained by Juliette Declerq of JDI in her recent report ‘The Euro’s fortune wheel has now turned’:

It is the inflexion point in these fixed income flows which is now responsible for the change in momentum in euro flows.

Quite simply, as QE started to effectively help reflate the Eurozone economy, portfolio outflows fleeing the deeply negative short end real yields started to peter out – to the benefit of inflows chasing sharply improving medium term real returns. Bond flows started to follow FX valuation considerations stemming from expected rather than observed interest rates differentials.

With money flowing out of the US, we can anticipate US equity and bond flows to start to accelerate as European carry traders liquidate assets and return to the EZ. To date, equity capital has been leaving the US – but has been more than offset by flows into bonds. But those bond flows may now be in reversal, especially if we have a rethinking of the global USD system whereby China and the oil countries have less reason to invest in US assets and make moves to price commodities in other currencies than the USD.

Who is loosening?

At present, Japanese and Chinese liquidity conditions are the ones showing major improvements. The BOJ has been printing so hard that it has bought ¾ of the Japanese ETF market, and increasingly it seems that flows are heading out of Japan and going abroad – which accounts for the mysterious weakness of the yen against the USD whilst most other currencies (AUD, EUR, CAD, and even GBP) have seen strong appreciation. The BOJ is doing something extraordinary, as Crossborder explain:

The BoJ is starting to behave more like an EM Central Bank and effectively running a pro-cyclical, rather than an anticyclical monetary policy. Hence, we expect Japan to behave in future more like a typical Asian EM.

The BOJ looks set to be the first developed central bank to entirely lose its credibility. In the meantime, expect flows of yen as the BOJ tries to keep present asset prices inflated as the Fed begins to pull the tablecloth from under the market without upsetting the spread.

Overall, next year could be the first year that multiple central banks move toward actual tightening or less QE (itself de facto tightening). Other banks such as the SNB have been doing back-door QE to offset the vagaries of the ECB. When the ECB slows, the SNB will also step away – magnifying the effect.

The yield signal

The thing to watch is bond yields. Growth continues to surprise on the upside, which theoretically is good for stocks and bad for bonds – and we have been seeing UST yields rise. Now, with the Fed tapering its bond portfolio from this quarter onwards, those yields could continue to rise. Eventually, the higher rates will start to feed through to the real economy, killing the recovery and potentially driving up the USD again, to the detriment of global markets.

Time will tell; for now China and Japan are in full expansion mode, and the popular themes driving markets are inflation and EM. With euros and yen flooding the market, we would expect dollar appreciation, not depreciation, on a relative weighted basis. Thus markets are taking a very sanguine view on long-term US rates remaining low, given the current level of the dollar.

Looking further out, if positional unwinds lead real rates to move far in excess of expected and actual growth, then all that happens is an increase in the cost of capital, which equates to margin compression – clearly negative for equities. Rates need to rise for a good reason in order to be supportive for equities. Caveat emptor.