Global Liquidity: End of an Era

Mid Week Bond Update

Global Liquidity: End of an Era

Four major central banks are winding down their decade-long high-liquidity policies; crude oil prices rose sharply since the end of December; U.S. credit spreads pulled back.

Global Liquidity: End of an Era


A look at four key central banks’ buying and selling of reserve assets since the onset of the 2008 global financial crisis is useful to understand what could happen next with the $14.4 trillion in assets now held by the Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE). 

Early in the crisis, the Fed had aggressively sold assets in order to make short-term paper accessible to buyers to help restore normality to the market.  But by June-July 2008, it reversed course with a buying binge intended to forestall a global recession driven, according to Fed thinking, in part by shrinking liquidity.

By September 2008 the Fed had become a net buyer.  Looking at 3 month rolling averages as shown in the chart below, by May 31 the Fed bought roughly $175 billion of Treasuries, mortgage-backed securities and more. By that time, the Fed had been joined in the effort by the BoE and, to a lesser degree, the BoJ -- bringing the total liquidity added during that three-month period to just over $215 billion. 
 

A Decade of Central Bank Policy Experiments – Winding Down?

Net Asset Purchasing Activity* by Four Key Central Banks, 2008 – 2019 (Forecast)

Chart courtesy of Western Asset Management.  Source: National Central Banks, Citi Research, as of 30 November 2018. * Note: All figures shown are presented on a 3-month rolling basis. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Now, with the Fed and the ECB starting to unwind these massive positions, market observers have been quick to blame the asset sales for increased market volatility, projections of declining global growth, and fears of a future spike in both inflation and interest rates.

Yet evidence of these dire developments is difficult to find.  Inflation, for instance, is most notable for not appearing at all. World commodity prices continue to be under downward pressure and central banks are finding it difficult to reach their target inflation rates. Nominal1 interest rates also seem to be dormant, with the Fed appearing to pull back on its own 2018 projection of a three-hike 2019.

Still, it would be rash to assume that former Fed Chair Yellen will get her wish that the Fed’s selloff will be akin to “watching paint dry”. As the projections at the lower right of the chart suggest, what’s been sold to date is only the tip of the iceberg.

But just as the QE flood of liquidity failed to generate runaway inflation, the progress of QT has the potential to be similarly anticlimactic.
 

On the rise:  Crude oil prices

The latest upward move in Brent crude oil spot prices, from the December 26 low of $49.93/bbl to  $61.33 (up 23%) on January 22 – and a similar move for WTI over the same period – may be the commodity’s most recent demonstration of the adage, “The cure for low prices is low prices”.

Even after the rise, Brent’s price is still a far cry from the early October peak of $86.74, achieved as fears associated with the partial embargo on Iran and spillover from the Syrian civil war faded. In the following months, OPEC and OPEC Plus2 met several times, both formally and otherwise, eventually resulting in Saudi Arabia stepping up with its pledge to cover any volume  shortfall in the broader market.

One result: the holiday week rally in crude oil prices cited above. But to be fair, other forces were at work, most notably a change in the sentiment surrounding the pace of the Fed’s widely-expected 2019 rate hikes. The combination of the two generated a rally in U.S. equities as well as in crude; the S&P 500 rose some 14% to 2675.47 intra-day on January 18 before pulling back on January 22.

 

On the slide: U.S. corporate spreads

The run-up in U.S. Corporate and High Yield spreads since the beginning of October was read by cautious fixed-income investors as an early sign of deteriorating credit conditions and a shot across the bow for believers in the continued breakneck pace of U.S. growth.

But since January 3, the aggregate option-adjusted spread (OAS) for U.S. High-Yields3 has fallen 115 basis points (bps)4 to 422 bps, while the spread for U.S. Corporates also pulled back (by 19 bps, to 138 bps).

Clearly, it’s too early to declare victory on the credit quality front; the suddenness of this move suggests market-specific forces are at work rather than longer-term trends.  One possible explanation is the strength of the rally in crude oil prices since the end of 2018. As crude oil prices rise, the credit position of high-yield borrowers in U.S. oilfields improves apace.  And along with optimistic talk of increased exports of energy, the outlook held by U.S. producers, transporters, borrowers and lenders could be bringing spreads back to a more relaxing level.

 

All data Source: Bloomberg, January 22, 2019 unless otherwise indicated.

 

1 A “nominal” interest rate is uncorrected for the effects of inflation over time.

2 OPEC Plus is an informal reference to the members of OPEC, plus other major producers such as Russia and Azerbaijan.

3 An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.

Values for OAS refer to the Bloomberg Barclays U.S. Corporate and U.S. Corporate High Yield Indexes as of January 22, 2019.

4 One basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).


Definitions:

G4 refers to four major developed economies: U.S., European Union, Japan and the U.K.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

Quantitative tightening (QT) refers to central banks' decreasing the excess reserves of the banking system through the sale of debt securities from their inventories.

 

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