Ok, it’s time to talk about the blowback from the ever-so-gradual rundown of the Fed’s balance sheet again.
One of the most amusing things to observe on a daily basis is the contortions popular pundits go through in order to “explain” why the unwind of accommodation will not lead to a reversal of the market dynamics that stemmed directly from that same accommodation.
That effort started a couple of years ago with attempts to advance actual, real arguments to support the contention that financial assets can still inflate in the absence of QE but ultimately, the sheer absurdity in contending that while QE led to gains, the rollback of QE won’t lead to losses became so readily apparent that the punditry resorted to claiming that QE didn’t actually catalyze the gains in the first place.
Those pundits are to be applauded for at least acknowledging the inherent ridiculousness in saying that although A ——> B, somehow the absence of A won’t lead to the reverse of B. But they’re to be lampooned for immediately pivoting to something even more ridiculous – namely the contention that $15 trillion in liquidity earmarked to catalyze a global hunt for yield somehow didn’t create the very hunt for yield we’ve all witnessed over the exact same time frame that the $15 trillion was deployed.
That’s pundits for you.
Unfortunately, they’re leading the lemmings off the cliff which is #SAD (to quote our self-vaunted, orange-faced commander-in-chief) because after all, the gains those lemmings have seen in their E*Trade accounts are “real” (depending on how you define “real”) and could thus be monetized for triple-digit gains. So far from doing retail investors a solid by insisting that QE isn’t behind the rally in risk assets, these pundits are actually lying (inadvertently or on purpose) to retail investors ahead of central bank normalization.
Of course every sellside strategist who isn’t pot-committed to the rosy narrative by virtue of being on the equities team knows full well what’s going on and very much unlike the Twitter pundits who spend their morning commute tweeting out charts of earnings growth and linking to each other’s blog posts, credit teams at the big banks will be happy to elaborate on the impact the rollback of global QE is likely to have on markets.
That doesn’t mean credit strategists are a dour bunch that’s predisposed to fearmongering. It just means that generally speaking, they understand that because A ——> B, less A means less B by definition.
Now cue BofAML’s Hans Mikkelsen who on the Thursday demonstrates exactly what I mean when I say that you can acknowledge reality without positing a disaster…
QT+tax reform+financial deregulation=OK
We know QE as the source of all good in financial markets. Now Fed quantitative tightening (QT) is unwinding that, which is scary and uncharted territory. There are (at least) two key negative impacts on the corporate bond market. First, the Fed will be buying less Treasuries and MBS, and any resulting weakness could spill over into the corporate bond market. Second, as the Fed winds down its securities portfolio they will be removing dollar reserves from the system (Figure 1), and thus if demand does not decline, tighten dollar funding conditions in the international markets (Figure 2). That would make it more expensive for foreign investors to hedge dollar risk via more negative cross-currency basis swaps.
However, we think these two negatives are more than mitigated by concurrent tax reform and financial deregulation, respectively. Should that against our expectation be insufficient any upward pressure on US interest rates will be met by large foreign inflows, which limits interest rate volatility.
At the end of the day, if you’ve “got a fever” and you want more of the same from risk assets going forward, you’re gonna need more QE/cowbell…
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