Another day, another debate about the effect central bank balance sheets will ultimately have on Treasury yields.
Last week we highlighted a pretty interesting piece from Bloomberg’s Cameron Crise who tested the extent to which Fed/ECB/BoJ balance sheets influence 10Y yields. Simply put, he found that their inclusion in a model that also counts core PCE inflation, the unemployment rate, the Fed funds rate, and Fed expectations seems to suggest that they don’t in fact matter as much as some folks think. As we noted at the time, that model probably suffered from a bit of chicken-egg-ing, but it was still a worthwhile exercise. Ultimately, Crise said his research suggested the market shouldn’t “believe the hype surrounding central bank balance sheets and Treasury yields.”
One thing to note when you hear this debate is that back in August of 2015 quite a few commentators started to ask whether China’s FX reserve liquidation (tied to Beijing’s attempts to control the pace of the yuan devaluation) would amount to QE in reverse and thereby serve to mute the effect of DM central bank asset purchases. Of course what China was doing wasn’t new. In many ways, Saudi Arabia’s move to kill the petrodollar in late 2014 marked the beginning of the end for the great EM FX reserve accumulation. There was quite a bit of global hand-ringing starting in early September 2015 about the “quantitative tightening” that China and Saudi Arabia had unleashed.
Now the debate outlined above centers on the Fed’s balance sheet (how quickly they’ll let it runoff) and on ECB tapering.
Read below as former FX trader Mark Cudmore weighs in with a less nuanced, but more straightforward assessment. Simply put, Cudmore notes what we said on Tuesday – namely that bears of any kind should be wary when central banks are (still) in the driver’s seat.
Major central bank balance sheets provide another reason not to fear a severe bond bear market any time soon.
- In dollar terms, the balance sheets of the Fed, ECB and BOJ are, for the first time ever, pretty much at parity. And China’s is also converging from above.
- Their combined assets amount to about $18.5 trillion, and are still growing. With the vast majority of that cash chasing liquid assets, it makes it pretty tough for bond vigilantes to prompt a sustained selloff, especially when there are no signs of rampant runaway inflation
- The panicked focus on the potential for the Fed to reduce its balance sheet is perhaps blinkered. Despite standing behind the world’s largest economy, the Fed will soon only have the fourth-largest balance sheet
- Based on recent trajectories, the ECB is set to have the largest balance sheet by next year. The European and Japanese authorities are accumulating assets at a pace that should easily compensate for any Fed reduction
- Of course, it’s worth noting that as the comptroller of the world’s reserve-currency, marginal Fed adjustments have a more immediate and direct impact on global liquidity. Financial assets will reflect that in terms of a short-term reaction to Fed changes, but the broader picture should temper assessments of how changes in the U.S. affect the world financial system
- Japan’s economy is less than 25% of the U.S.’s, so the BOJ’s balance sheet trajectory should be drawing the most attention from those who question the long-term sustainability of such debt piles. Currency adjustments may ultimately be the method of fixing the problem. The end- of-2016 dip in the BOJ’s balance sheet was purely yen related and shows why — despite protestations to the contrary — they are so focused on the exchange rate
- In China’s unique case, the PBOC’s balance sheet is dominated by about $3 trillion of FX reserves and is therefore much less worrying
- Bears, not just bond bears, beware. There remains an exorbitant amount of liquidity in the system chasing financial assets