Curious why everything is being bought in the aftermath of last week’s ECB’s unprecedented announcement, and both bonds and stocks are either at or just shy of record highs ignoring completely the worst US nonfarm payroll print of 2014? JPM’s Nikolaos Panigirtzoglou explains why.
From “The ECB’s liquidity boost”, here first is the background on where in the global central bank central-planning experiment we stand right now:
The ECB President stated in this week’s press conference that the ECB’s forthcoming programs, i.e. TLTROs coupled with ABS and covered bond purchases, could take the ECB’s balance sheet back to early 2012 levels, i.e. to €3tr from €2tr currently. These remarks, not only suggest that the ECB might have a target in mind regarding the size of its balance sheet, but raise questions about the boost to global liquidity from prospective ECB actions.
In aggregate, G4 central balance sheets started rising rapidly from the end of 2010 driven by the Fed’s QE2 followed by the BoE’s QE, ECB’s LTROs, Fed’s QE3 and BoJ’s QE. As a result of these central bank actions, G4 central bank balance sheets expanded by almost $4tr over 4 years i.e. by $1tr per year since the end of 2010 (Figure 1). With the ECB aiming at a €1tr expansion of its balance sheet, this $1tr per year pace in G4 central bank balance sheet expansion is likely to increase rather than decrease from here, despite the Fed’s tapering. The BoJ is already expanding its balance by close to $650bn per year, so adding a similar pace of increase for the ECB’s balance sheet (€500bn or $650bn per year) should result in an annual pace of G4 central bank balance sheet expansion of $1.3tr, even as the Fed ceases bonds purchases.
This ECB-driven quantitative expansion is hitting the global financial system at a time when liquidity is already very high. And this is true for both “narrow” or “banking sector liquidity” and “broad” or “non-bank sector” liquidity.
The G4 banking system is already flooded with excess reserves of around $4.5tr i.e. reserves commercial banks have with central banks in excess of what they need to meet usual liquidity needs.Given that the banking system cannot get rid of reserves in aggregate, these zero yielding reserves become the “hot potato” that banks try to pass to other each until the relative pricing is adjusted enough to remove the incentive for banks to get rid of these reserves. With the ECB aiming at increasing the amount of excess reserves even further via its TLTRO/bond purchase programs, G4 narrow or banking sector liquidity should exceed $5tr, exerting even more downward pressure on 2-5 year government bond yields of core countries, the preferred habitat of banks.
This is where global liquidity currently stands:
To assess excess money supply, we update the model we previously published in Flows & Liquidity, Apr 26th 2013. Beyond nominal GDP and financial wealth, i.e. the stock of tradable bonds and equities in the world, the model includes an uncertainty variable. Uncertainty is important as it makes agents hold more cash during periods of elevated risk perception, for precautionary reasons. We proxy uncertainty via the US monthly index constructed by Baker, Bloom and Davis. To measure policy-related economic uncertainty, they construct an index from three types of underlying components. One component quantifies newspaper coverage of policy-related economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty. This uncertainty proxy is shown in Figure 2 along with its smoothed version. This uncertainty proxy declined sharply over the past two years and has completely unwound the post Lehman increase.
To estimate the gap between money supply and a medium-term demand target, we regress real money balances, global M2 deflated by global CPI, against 1) real GDP (i.e. the level of nominal GDP deflated by global CPI), 2) real financial wealth (i.e. the total capitalization of global bonds and equities deflated by global CPI), and 3) the uncertainty proxy described above. To remove the impact of FX changes from our global money stock measure, we aggregate the M2 stocks of various countries at constant (today’s) exchange rates. The regression results are shown in Figure 3. All three variables are statistically significant with a positive sign as predicted by theory.
Excess (i.e. the residual in our model) money supply is currently in record high positive territory. The current residual suggests that global money supply which stood at $68tr at the end of August is $5tr above our estimated medium-tem money demand target. The residual of the regression turned positive in May 2012 and has risen steadily since then. This is both because of real money supply increasing and money demand decreasing due to lower uncertainty (Figure 2: Global M2 reached $68tr in August this year and is up by $15tr or 29% since the end of 2010 when G4 central bank balance sheets started rising rapidly. The capitalization of both bonds and equities in the world had risen by a similar 31% over the same period and the current pace of M2 growth suggests that global equities and bonds should continue to grow by at least 6% per annum.
Of this $15tr increase in global M2 since end 2010, $5tr was due to G4 and the rest $10tr was due to the rest of the world, mostly EM. Strong credit growth in EM economies has boosted our measure of excess liquidity in recent years and this force led by China continues unabated. It is often mentioned that this Chinese or EM liquidity is trapped within EM. We disagree. It is true that domestic economic agents in China and other EM economies face restrictions in deploying their capital abroad. But domestic liquidity in China and EM is channeled to the rest of the world via reserve accumulation, i.e. via the official sector, as capital restrictions put upward pressure on EM currencies.
Prospective ECB actions are likely to widen the above $5tr estimated gap between global money supply and demand. That is, the ECB’s quantitative expansion is hitting the financial system at a time when broad liquidity is also very high. The rise in excess liquidity, i.e. the residual in the model of Figure 3, is supportive of all assets outside cash, i.e. bonds, equities and real estate. The current episode of excess liquidity, which began in May 2012, appears to have been the most extreme ever in terms of its magnitude and the ECB actions have the potential to make it even more extreme, in our view. Before then, there were three major episodes of excess liquidity (i.e. positive residual) in our model: 1993-1995, 2001-2006 and Oct 2008-Sep 2010. These were periods of strong asset price inflation suggesting that excess liquidity could have been a factor supporting markets at the time.
You don’t say.
It is also important to note that liquidity is not constrained by borders. For example, foreign institutions could also sell ABS or covered bonds to the ECB, so the prospective injection of liquidity by the ECB could reach foreign as well as domestic institutions. Anecdotally, both the Fed and the BoE have bought significant amount of bonds from foreign institutions during their QE operations. In addition, in a global and interlinked financial system, via arbitrage, the ECB operations can end up suppressing yields of higher yielding bond universes outside the euro area by more than domestic bonds.
Finally, add JPM to the long list of entities, from billionaires Icahn, Zell, Soros, Druckenmiller, to the BIS, to and increasing number of Fed presidents themselves, warning that the fun days of bubble inflation are almost over.
These liquidity boosts are not without risks. We note that they risk creating asset bubbles which when they burst can destroy wealth leading to adverse economic outcomes. Asset yields are mean reverting over long periods of time and thus historically low levels of yields in bonds, equities and real estate are unlikely to be sustained forever.
Translation: JPM is slowly but surely also getting out of dodge.