Will the Great Taper Bring on GFC 2.0?

By David Llewellyn-Smith, founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. Originally published at MacroBusiness

Via Citi:

After many years of sizable increases in central bank balance sheets (Figure 2), major changes in central bank purchases are approaching, as i) the Fed is due to announce balance sheet reduction in September and begin implementing it in October, ii) the ECB will probably announce a reduction in its net purchase volume in October (to begin in Jan-18) and will probably end its net asset purchases in H2- 2018. In addition, the BoJ net asset purchases have fallen and we expect them to continue to fall, even though the BoJ now pursues a yield-targeting policy. Overall, advanced economy (AE) net asset purchases are likely to fall from $100bn/month currently to roughly zero by end-2018 (Figure 1) and aggregate AE central bank balance sheets are likely to peak soon (in dollar terms around end- 2018 and relative to GDP in mid-2018).

This note discusses the trajectories of central bank asset purchases, their drivers, exit strategies, potential implications and risks. The change in central bank purchases is mostly due to a better economic backdrop in AEs – much lower unemployment rates and somewhat higher inflation – even though political reasons and technical factors also play a role. Central banks will tread carefully and the direct impact of global tapering on the real economy will likely be modest. But there is a material risk in our view, that major asset price corrections could be triggered by this global tapering (Figure 3).

If global tapering were to puncture asset bubbles, this could magnify the effects of global tapering on the real economy, by discouraging investment, lifting corporate defaults and leading households to retrench and could therefore be associated with a significant global economic slowdown, too.

Why should global tapering matter?

In our view, the direct effects of global tapering on global growth and inflation are likely to be modest. The overall impact of global tapering would, however, crucially depend on the financial market reaction. Major corrections in asset markets would likely cause a more severe slowdown in global growth, ie the causation would run from asset markets to the real economy.

Such corrections may be caused by global tapering or simply triggered by it. In the latter case, global tapering probably only determines the timing of the fallout, which would in any case have taken place.

Why would asset prices fall?

The footprint of central banks in financial markets is very large. The combined asset holdings of the five central banks with recent QE programmes (BoE, BoJ, ECB, Fed, Riksbank) amount to $11.5trn, or 26% of the outstanding values of those assets classes.

Our colleagues in Credit Strategy eloquently laid out the argument for why asset valuations could be threatened by global tapering, based on portfolio balance effects of these purchases and the view that many assets are overvalued currently.

The portfolio balance channel

The decline in CB net asset purchases will lead to a rise in net supply of the assets that central banks were previously buying, which would need to be absorbed by the private sector (Figure 10). The net supply of these assets to the private sector is due to rise from -$200bn in 2016 and 2017 to $1.2trn in 2018 and $1.9trn in 2019 (Figure 11). Within that, the net supply to the private sector of US Treasury securities is set to rise by more than $230bn between 2016 and 2018 (2017 issuance will probably be distorted by debt ceiling issues), and by about $170bn for US MBS. Eurozone net sovereign bond issuance to the private sector could rise most sharply (from admittedly very negative amounts) as the ECB phases out its APP.

Standard portfolio balance theory suggests that for a rise in net supply to be absorbed, prices of assets would have to fall (strictly, be lower than they would otherwise have been) and the more so, the less substitutable they are with other assets and the less elastic demand is to decreases in their price, both in the nearterm (which mostly depends on the market’s liquidity) and in the long-term.

Substitutabilities between different assets and demand elasticities of investors to changes in asset prices are key. The bulk of central bank holdings is in sovereign bonds – e.g. the Fed currently owns $2.5trn of US Treasury securities (18% of the outstanding), the ECB owns €1.8trn (23%) of Eurozone sovereign bonds and the BoJ ¥431trn of Japanese government securities (46%).

But we would expect the largest asset price moves to often be in other assets, notably those which are more risky and for which demand tends to be more volatile. US high-yield corporate debt, Eurozone periphery sovereign bonds, Eurozone corporate bonds, global equities, EM assets are among the asset classes in focus.

In some of these markets, central banks are also very present: for instance, the Fed owns 29% ($1.8trn) of agency MBS, the ECB 27% of Eurozone covered bonds and 15% of Italian sovereign bonds. For all of these net supplies to the private sector are also set to rise quite sharply, even though from deeply negative levels in the case of Eurozone covered bonds and Italian sovereign bonds most recently. The ECB also buys a significant share of the gross issuance of Eurozone IG nonfinancial corporate bonds. In others (e.g. equities or EM assets), the effect of central bank purchases are indirect.

One concern is that global tapering would lead to higher implied and realized volatilities of many asset prices (which have tended to be very low of late, at least in the equity market). Increases in these volatilities could turn out to be self-reinforcing, as rising realized volatility could induce investors to try to exit their positions, which in turn could lead to further price declines and reinforce higher volatilities.

Overall, we would therefore expect, to the extent that investor risk aversion rises and/or the economy weakens during the global tapering episodes, the prices of sovereign bonds may fall less or indeed rise (ie yields fall) as central banks retreat from those markets, due to safe-haven demand for these assets, as other asset prices fall (more). Like our colleagues in credit strategy, we stress that the drivers and the effects are potentially global.

While the supply to the rest of the market (i.e. excluding the central banks) of the securities central banks now hold would be rising under global tapering, the availability of central bank reserves would be declining, other things equal. However, we are not unduly worried about this aspect, including as there are significant ‘excess’ reserves currently, central banks and regulators are aware of these issues.

It is also worth noting that we do not expect global central banks to become significant net sellers of private sector assets for the time being, ie the stock of financial assets held by AE central banks will continue to rise for some time and only start to decline very slowly in 2019.

In general, we think that both stocks and flows matter for asset prices. Indeed, unless markets are completely myopic, portfolio balance theory implies that all current and anticipated future asset stocks (relative to the demand for these assets at given prices and yields, that is, relative to income or wealth), should matter for asset prices and the real economy. Because current flows and anticipated future flows drive anticipated future asset stocks, flows matter even in the ‘stock-oriented’ portfolio balance model. In very liquid, orderly markets, only unanticipated flows or changes in flows affect asset prices and yields today – through their impact on future anticipated asset stocks relative to the future demand for these assets at given yields and prices.

In practice, there are no perfectly liquid markets, and it is therefore likely that even fully anticipated reductions in central bank purchases (‘the flow effect’) could push down asset prices at least temporarily, as financial markets try to digest the rising net supplies. In liquid markets (US Treasuries, Bunds, JGBs etc.) we expect that much of that effect would be temporary and modest. This is not true for illiquid markets like those for Eurozone periphery sovereign debt and most EM securities.

Are asset markets overvalued?

As long as financial markets are orderly and relatively fairly valued, changes in relative asset supplies should only have a moderate effect on asset prices and through that on the real economy. It is, of course, very difficult to ascertain whether assets are fairly valued. But we are concerned that a number of key asset valuations appear rather stretched, according to a range of metrics. For instance, the value of the US stock market to GDP is at historically high levels and the cyclically-adjusted P/E ratios are similarly elevated (Figure 15). Moreover, we have gone for an unusually long period without a stock market correction (Figure 16).

If past, present and anticipated future central bank policies have been, at least in part, responsible for pushing asset prices away from their fundamentals, then the retreat of central banks from these policies would strengthen the case for expecting a pullback in asset prices – in that case, the retreat of central banks would cause the fall in asset prices.

But even if central banks were not a cause for their overvaluation, central bank pullback could be a drag for valuations. In that case, the bubble would burst eventually anyway, and global tapering would only affect the timing of it – it would be the trigger.

The timing of any asset price reaction is indeed another source of major uncertainty. With perfectly efficient markets, we would expect all financial markets to adjust as soon as new information becomes available. However, in fully efficient financial markets, relative asset demands and supplies – both stocks and flows – are not among the drivers of fundamental asset valuations and major asset bubbles are unlikely. If one believes that asset valuations can stray from their fundamental valuations (as they currently appear to), one may therefore also be sympathetic to the view that financial markets react only (or mostly) as purchase changes are realized and not just as new information gets released.

Good stuff, that. My own view is that the Great Taper will end the global business cycle, but not before we get one more march higher in DM asset values as bond prices rally around tapering into lowflation.

I wouldn’t be hanging around in EM assets to find out what effect it will have there henceforth.

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  1. Sound of the Suburbs

    How much real wealth did those Tulip Bulbs contain in 1600s Holland?
    Nothing’s changed.

    Wealth – real and imaginary.
    Central Banks and the wealth effect.

    Real wealth comes from the real economy where real products and services are traded.

    This involves hard work which is something the financial sector is not interested in.

    The financial sector is interested in imaginary wealth – the wealth effect. Hardly any of their lending goes into productive lending into the real economy.

    They look for some existing asset they can inflate the price of, like the national housing stock. They then pour money into this asset to create imaginary wealth, the bubble bursts and all the imaginary wealth disappears.

    1929 – US (margin lending into US stocks)
    1989 – Japan, UK, Canada, Scandinavia (real estate)
    2008 – US (real estate bubble leveraged up with derivatives for global contagion)
    2010 – Ireland (real estate)
    2012 – Spain (real estate)
    2015 – China (margin lending into Chinese stocks)

    Central Banks have now got in on the act with QE and have gone for an “inflate all financial asset prices” strategy to generate a wealth effect (imaginary wealth). The bubble bursts and all the imaginary wealth disappears.

    The wealth effect – it’s like real wealth but it’s only temporary.

    All that QE has to go somewhere and it sure as hell isn’t in the real economy as can be seen from the inflation figures.

    Refer to fundamentals to distinguish between real and imaginary wealth in markets. It’s what they are for.

    “Stocks have reached what looks like a permanently high plateau.” Irving Fisher 1929.

    Did you check the fundamentals?
    Most of that wealth is imaginary.

  2. Sound of the Suburbs

    Neo-liberalism backed us into a corner where interest rates can’t be raised.

    Capitalism goes wrong in the 1930s, 1970s and now.

    Each version of capitalism gives power to a different group and as they realise that power they break the system.

    The reckless bankers blow up the global economy in the Wall Street crash of 1929 as supply side, orientated economics gives them too much power.

    The reckless union leaders lay the economy low in the 1970s as demand side economics gives them too much power.

    The reckless bankers blow up the global economy in the Wall Street crash of 2008 as supply side economics gives them too much power.

    The pattern becomes obvious.

    In the Keynesian era the target was full employment.

    This eventually gave too much strength to workers who became more and more militant in their demands.

    All predicted way back in 1943 by Kalecki.

    In the supply side, orientated eras of the 1920s and now, they use neoclassical economics that doesn’t look at private debt, and the bankers have a field day with their debt products.


    The UK:
    It’s that neoclassical economics again, no one was looking at private debt.


    We were travelling down the dead end street of debt with Thatcher and Blair and by 2008 the economy was saturated.

    What can we do now?
    Keep interest rates low to stop a debt implosion (debt deflation).
    Maintain asset prices with QE.

    The system is broken.

    1. Sound of the Suburbs

      All that effort by the Right to roll back the “New Deal” and then they use neoclassical economics, which is awful.

      The Classical Economists of the 19th Century were only too aware of the two sides of capitalism, the productive side where wealth creation takes place and the parasitic side where wealth extraction takes place.

      It all disappears in early neoclassical economics.

      The distinction between “earned” income (wealth creation) and “unearned” income (wealth extraction) disappears and the once separate areas of “capital” and “land” are conflated.

      The problems with rentier activity in the economy are hidden in economics.

      “Income inequality is not killing capitalism in the United States, but rent-seekers like the banking and the health-care sectors just might” Nobel-winning economist Angus Deaton

      The problem still exists in the economy.

      It was never going to work.

      1. Sound of the Suburbs

        What is the investor’s main concern?
        Maximising profit

        How do you maximise profit?
        Minimise wages

        What sets the minimum wage?
        The cost of living

        The cost of living = housing costs + healthcare costs + student loan costs + food + other costs of living

        Do the calculations for the West and China, no wonder all the investors are flocking there.

        A low cost of living is essential for free trade.

        Neoclassical economics had to hide the effects of the cost of living to conceal rentier activity.

        The repeal of the Corn Laws ushered in the era of Laissez-Faire.

        The businessmen wanted lower corn prices, to lower the cost of living for lower, internationally competitive wages.

        That’s it, being able to pay internationally competitive wages as known by the Classical Economists.

  3. Jim Haygood

    It all sounds so logical and inevitable — central banks’ leveraged punt on financial assets tapers off … and with their fraudulent kited-check bid removed, asset prices fall back to natural levels.

    Indeed, the question becomes “How could it NOT happen?”

    One scenario is that the long-awaited inflation, which has callously ignored the rain dances and sorcery of the central planners to their intense embarrassment, suddenly takes off with a bang. Long-depressed nominal GDP growth — currently running at a feeble 3.8% yoy in the USA — surges back above the 6.0% level that used to be seen only in the depths of recession.

    In such a scenario, real interest rates go more negative than they already are. With below-zero real rates, accumulating stocks, properties, commodities and collectibles that are rising faster than one’s nominal financing rate becomes a profitable game indeed.

    While this scenario may sound improbable, it’s equally improbable that the nine-year reign of Bubble III — our last, best chance on earth — ends in an ignominious whimper rather than with a planet-shattering firestorm of leveraged speculation and 13-year-old stock pickers turning tiny to trillions on their iPhones — to the extent of requiring an updated, 21st century-focused edition of Extraordinary Popular Delusions and the Madness of Crowds.

    Remember, folks — buy the mushroom cloud. ;-)

    1. cojo

      Long awaited inflation, will it ever arrive!?!?

      What has suppressed any inflation over the central bank reflation is likely a combination of the debt-deflation after the credit bubble popped, as well as something that is not mentioned in this article, demographics. As I understand it, the stagflation of the 70’s was partially attributable to the baby boomer bubble starting to enter the workforce, hence, their buying power juicing up asset prices. The other contributor was Nixon’s taking the US dollar off the gold standard to help finance the costs of Vietnam.

      What we are in the midst of today in the US as well as Europe and Japan, is a demographic shift where the boomer bubble is entering the retirement phase and starting to draw down financial assets as well as remove liquidity from the economy.

      Then next generational bubble is the millennials. However, they have been hobbled by the global financial crisis and student loan debt so haven’t been able to reach their peak earning potential. Perhaps, once this happens inflation will reappear.

  4. WobblyTelomeres

    “With perfectly efficient markets…”
    “However, in fully efficient financial markets…”

    Will one of you kind people please explain the difference between “perfectly efficient” and “fully efficient”?


    1. Ignacio

      Let me try,

      Fully efficient means that no one can be cheated
      Perfectly efficient means that common people will be cheated

  5. Susan the other

    Central banks are determined not to destroy economies; to act cautiously. Looking at China it occurred to me (prolly w/out understanding much) that China, like the US, can control the yuan no problem, but it cannot control the economy – which is the opposite of our economy. The Chinese economy is on fire while ours is in the tank. Yet both of us are messing around with our currencies in exactly the same prescribed way which looks a lot like trickle-down. It appears that economies are in service to currencies (stability of) and this in turn should provoke some serious rethinking about unchecked inequality. So why does it seem to be so verboten to follow neoliberal policies to their inevitable result? Is inequality the goal? Just trying to bring this economic analysis full circle in my own thinking – because it really doesn’t sound like economic analysis at all.

  6. Chauncey Gardiner

    No fan of the monetary, legal, deregulatory and financial markets policies that were adopted before and after the collapse of Lehman and have been perpetuated far beyond any reasonable shelf life; together with fiscal austerity in infrastructure, public education, and other domestic spending that would benefit We the People.

    With the reported US unemployment rate only a little over 4 percent, it seems to me that we could see a pick-up in wage-driven, cost-push inflation, a steepening in the yield curve, and a rise in long-term interest rates soon enough; with foreseeable effects on financial assets and real estate prices in this highly debt-leveraged economy. Also seeing the US dollar weakening vis a vis the euro despite the positive difference between US and EU interest rates.

    1. Sound of the Suburbs

      It is RT, but even your man Michael Hudson only gets air time on RT (how I found him).

      Richard Werner has been watching incredulously as the same mistakes are made over and over again.

      He was in Japan around 1989 and has worked it all out.

  7. David Mills

    Jean-Paul Sartre wrote about the position of the central banks – No Exit. Even if they taper, they can’t unwind the positions because the money supply would have to expand accordingly in order for a counterparty to have enough cash to pick up. If the cb’s carry their fixed positions to maturity, then the money supply contracts as the (hypothetical) principal is repaid. Looks like a Hobson’s choice to me…

  8. Usonian

    The idea that central banks will ‘taper’ or withdraw support for financial markets is… uh… quaint. Who really believes that’s going to happen? At the first sign of any pull-back, they’ll be buying again with two fists. I’ll certainly die with CB rates pegged at or near zero, and be paying $50 for a hamburger by 2030.

  9. OpenThePodBayDoorsHAL

    Money stores labor and enables it to be transported across space and time, and money that took no labor to create cannot reliably perform this function, the temptation to create too much of it is simply too great.

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