Central Banks About To Break The Market
I think that many investors who are saying the Fed’s balance sheet unwind will be a nothingburger are tired of the story and they think it’s overkill. They are also myopic in their thinking. The chart below shows that even though we have been talking about an unwind and tapering for many months, not much has been done yet. The central bank liquidity as a percentage of GDP is still higher than it has been for most of this recovery. That’s about to change as a steep decline starts in 2018. When I say investors who focus on the Fed are being myopic, I mean that the reason the unwind is so critical is because it is happening along with global tapering. If the Fed unwound its balance sheet while the ECB was buying 80 billion euros in bonds per month, it wouldn’t be a big deal, but that’s not the case.
In a previous article, I showed the rate of change of central banks’ balance sheets compared with the S&P 500 rate of change on a year over year basis. They were nearly identical. We don’t know for sure if a selloff will be caused by this latest decline in central bank purchases, but it doesn’t look promising. The chart below is emerging market credit impulses. As you can see in the chart, it almost perfectly lines up with the central bank asset purchases. Lately the credit impulses have stagnated as some tapering has occurred. It looks like the credit impulses will start to fall in the next few months if their relationship with central bank purchases continues. That will be another indicator to watch out for in the next 3-18 months.
The chart above shows that the shrinking of the balance sheets will start in 2019. They haven’t shrunk since at least 2006. I expect significant volatility and some economic effects in 2018. It’s tough to know how much QE is improving the economy because growth has been weak. Is it possible that growth would be worse without it? Certainly, some weak corporations have benefited from low junk bond yields. If the central banks are creating the scenario for them to exist, it is effectively subsidizing weak firms. This supports the labor market in the short term, but hurts productivity because those inefficient firms shouldn’t exist. There is no question that if yields increase in 2018, there will be a large swath of bankruptcies across Europe and America.
