2017 Q4 Outlook: What happens when the liquidity spigots start closing?
Q4 outlook: The great balance sheet unwind begins

  • In Q4, the fed will start to unwind quantitative easing (Q/E), the biggest experiment in recent monetary history
  • While starting slowly, the liquidity drain will equal the size of the second Q/E programme at its peak, reducing global liquidity by 600bn USD on an annualised basis
  • This has far reaching implications for global growth and financial markets, shaping the outlook for the coming quarters
  • Unless other drivers take over the baton from cheap money, we are likely to see rising volatility and headwinds to risk assets, but still low core rates

1. Setting the stage: An era of ultra loose liquidity is coming to an end. Why is this all important?
In short, because one of the most important – if not the most important – macro driver behind asset returns in the post-crisis years is changing direction. Starting in October, the Fed’s Q/E wind down marks the beginning of the end of an era of ultra-cheap and abundant liquidity. A monetary regime shift is taking shape. Unwinding the Fed’s bloated 4.5 trn USD balance sheet means the frequently cited wall of liquidity will shrink, slowly at first, then gradually gathering pace to reach a “peak velocity” of 600 bn USD annualised liquidity withdrawal. In size, this equals QE II – just in reverse, so to speak. Money matters for markets, and as the liquidity regime changes, the market regime will likely change as well.

As was the case with Q/E I, II and III, the unwind of the Fed’s balance sheet is unprecedented. There are no textbook examples of how this will play out in the financial markets and the global economy. Most analysts agree that the wall of liquidity emanating from ultra-loose monetary policy post-Lehman was an all-important driver behind asset returns. Interestingly, there’s much more disagreement on the impact of the unwind of Q/E. Whether other return drivers will replace the wall of liquidity will be highly dependent on the market and macro reaction once quantitative tightening has been rolled out.

Let’s assume no other driver fills the gap: Growth stays low, while the Fed is moving on with its balance sheet reduction. Will other big central banks come to the rescue? The Bank of Japan continues to pump money into the system. So far, so good. The ECB, however, will almost be forced to reduce its bond buying in 2018 as it will soon run out of bonds to buy. China’s central bank is already contributing to slower liquidity growth as it is curbing shadow banking activities and seeks to reign in financial risks. So apart from the Bank of Japan, the liquidity flows from other central banks, while not reversing, are slowing down as well.

As a consequence, a reduction of the Fed’s balance sheet will only accelerate the net tightening of global liquidity conditions already in place. This is even more the case if quantitative tightening results in a renewed strengthening of the US dollar, reducing the dollar value of other central banks’ balance sheets. Being the world’s number one reserve currency, it is ultimately dollar liquidity that matters.

All taken together, we think there’s no reason to be complacent about the great unwind of Q/E. Complicating things further, keep in mind that inflation still is far below the Feds’ target. While the Fed admits it has no clue why, it still continues the tightening process. Therefore, this episode differs from “normal” tightening periods. Instead of inflation, financial stability concerns seems to be a key reason for the balance sheet reduction. Q/E has driven asset prices to “somewhat rich levels” according to Fed-chief Yellen herself. Although the Fed has a poor track record when it comes to asset price targeting, quantitative tightening makes sense in order to limit financial risks further down the road. But from a real economic perspective it also means that downside risks for the real economy might be higher than usual under Fed tightening periods.

That said, the Fed is aware of the risks, which is why it goes about the balance sheet reduction very slowly. Needless to say, Japan’s repeatedly failed attempts to exit extremely loose monetary policy are fresh in our memory. But given relatively robust economic momentum in the first half of 2017 and the usual time lag before inflation reacts to economic activity, the balance sheet unwind is a risk worth taking from a central bank perspective. Although quantitative tightening carries significant risks, staying put with an unchanged balance sheet might be the riskiest of all strategies.

2. Does money matter? The liquidity reduction and the economic outlook

Since the great financial crisis, real money growth has had a remarkable lead relative to global economic activity (see graph 1). So in terms of growth drivers, central banks might have been the frequently cited only game in town. With a one year lead, real money growth correctly predicted the slowing of the global economy during China’s hard landing fears in 2015 as well as the synchronised global recovery over the last year and a half or so.

Looking ahead, real money growth has already been slowing in recent months, signalling weaker economic momentum going forward. Slower money growth is not only due to tighter supply (i.e. central bank tightening), it is also driven by weaker demand for loans etc. Importantly, this does not take the Fed’s balance sheet reduction into account. A further reduction in money growth due to liquidity withdrawal from the Fed would add to the downside risks in liquidity and real GDP growth.

Other growth drivers could of course take over from here, especially if the money multiplier is being revived. So far, the post-Lehman flood of liquidity is largely stuck in the financial system. Were we to see renewed confidence in the non-financial sectors, this would boost loan demand as well. While this wouldn’t change the fact that central banks’ liquidity supply is scaled back, the real growth impact of the remaining liquidity would be much higher. Simply put, there would be more “bang for the buck”, as money would actually be put to work in the real economy rather than simply slush around in the financial system driving up asset prices.  

For now, the economy is by-and-large still in wait-and-see mode. Therefore, it is hard to square the liquidity-driven downside risks to growth with a market-implied growth expectation at pre-Lehman levels, (see graph 2). A possible explanation: Hopes for bold fiscal stimulus from the US administration seem to be increasing. Small cap stocks as well as tax-sensitive stocks have rebounded strongly as of late. We might be approaching a make-or-break moment for Trump’s tax plans in the coming months. This could be the trigger for the positive money multiplier scenario described above.

Although our sceptical view on Trumponomics and reflation hype has proven largely correct so far, recent political events have taught investors to be cautious about building their market views primarily on political factors. For now, we therefore choose to focus on the signals emanating from liquidity factors. On this basis, growth is likely to slow in the coming quarters, although no sharp deceleration is in the cards. But as there is widespread optimism for the global synchronised recovery to continue and growth estimates are being marked up, the risk-reward in betting on continued growth upside seems unattractive. We remain cautious, observing how broader macro variables will react once the monetary drain takes effect.

Graph 1


Graph 2


3. How will markets react to the Fed’s balance sheet unwind?

First, the Fed’s balance sheet unwind points towards higher volatility going forward. Ultra-loose monetary policy has been a precondition for historically low volatility. Volatility has tended to increase around the time the Fed makes major adjustments in hawkish directions, in particular when quantitative measures are used (see graph 3). Going forward, both the quantity and the price of money will be adjusted. As the “central bank put” consequently weakens, investor confidence is expected to become more shaky and volatility should slowly creep higher. This is already evident in the currency markets, where implied volatility has increased over the last couple of months. Arguably, currencies are less ”manipulated” by unconventional monetary policy than other markets, which is why FX could be a first mover in a more volatile direction. Also, keep an eye on markets that have benefitted the most from low volatility and liquidity abundance. High yield bonds naturally spring into mind. They underperformed relative to investment grade bonds during recent weeks, and this might continue if the liquidity reduction plays out as we expect.

What about interest rates? Some opposing forces are at work here. On the one hand, the Fed’s decision to stop reinvesting amounts from maturing bonds means less net demand for fixed income assets, driving yields higher.. On the other hand, keep in mind that reduced liquidity growth means monetary tightening. Tightening ultimately is deflationary, especially since it seems to be more driven by financial stability concerns rather than higher growth and inflation (still far from the Fed’s target). This effect points towards lower interest rates in the medium term. Also, the structural drivers behind low rates, such as an ageing labour force and high debt levels, are not going to fade anytime soon, which will keep a lid on interest rates.

Short term, the first effect might drive interest rates higher. Medium term, we think investors may put more emphasis on the latter factors, especially since the prevailing macro uncertainty supports demand for safer assets. The Fed’s balance sheet unwind is therefore unlikely to create sustained upward pressure on core government bond yields and the yield curve may be set to flatten further. In the very short term though, increasing hopes for bold tax cuts in the US might cause a short-term spike in yields.

That said, if this view on interest rates proves to be wrong and rates rise significantly, it could add to the downside risks to global growth. After all, the global economy is still very indebted, increasing the sensitivity to higher interest rate and a stronger US dollar, that most likely would follow. Caveat: If the interest rate increase is reflecting lower money supply as well as genuine improvements in the growth potential and therefore better return prospects, the negative effect would still be relatively short lived.

Equities are a different story. They have outperformed fixed income assets strongly in periods of an expanding Fed balance sheet (see graph 4). Vice-versa, a reduction in the balance sheet should create headwinds for equities, especially for the parts of the market that benefitted the most from the liquidity flood. We expect a less stable trajectory for equities and lower returns in the coming months. That being said, if the status quo prevails with growth staying resilient, the equity risk premia as such still seems attractive relatively speaking.

Graph 3


Graph 4


During the summer months, our short-term indicators pointed towards equities outperforming bonds, primarily because a weak US dollar so far outweighs monetary tightening on other fronts. However, looking further ahead, we see limited potential in risk assets relative to safer asset classes from a risk-reward perspective. Granted, equities continue to look attractive relative to bonds. But valuation might be a dangerous market guide when structural shifts are taking place in the overall liquidity regime. In addition, signs of a cyclical peak in economic momentum combined with relatively widespread economic optimism add to the risk of falling into the proverbial value traps. The most obvious upside risk, in our view, would be the revival of the money multiplier described previously, as it basically would compensate for a drain in central bank money.

About Nordea Asset Management
Nordea Asset Management (NAM, AuM 219 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 332 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients.  NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.06.2017

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