By Eric Peters, CIO of One River Asset Management
“Since central bankers are enacting monetary policy by acting like market participants, let’s analyze them like investors,” said Lindsay Politi, PM for One River’s inflation-strategy.
“Central banks are the biggest whale in financial market history. And we’ve all seen what happens when a whale needs to exit. The catalyst is always an unaccounted risk, a surprise event, or an incorrect assumption,” said Lindsay. “Whether it’s a margin call that can’t be met, a risk officer shutting it down, or client redemptions; there’s a point where every ordinary investor is forced to liquidate.”
If the position is big enough, a bubble bursts, and risks shift from being idiosyncratic to systemic.
“While global central banks were building their $31trln portfolio, there was little concern about systemic risk because they don’t have the same limitations as others.” There is practically no limit to how much they can buy, no return target, no traditional pain threshold from market losses.
“Because central banks don’t have stops like ordinary market participants it was assumed there no stop at all. But central banks, explicitly or implicitly, have the same stop. They are required to respond to inflation,” said Lindsay. “And now they’re getting stopped out.”
Because inflation is forcing the end of the QE trade, it will be the dominant driver of behavior for years, if not decades, as markets digest this unwind.
“Central banks did not spend the 1960s deliberately inflating asset prices, so while inflation punished markets in the 1970s, it did not force a central bank position unwind. This is why analogs to the 1970s are tenuous,” explained Lindsay. “The full extent of the QE trade will be impossible to quantify except in hindsight because it almost certainly spread in ways that aren’t entirely clear yet but are surely staggering,” she said.
“Sometimes in my role I’m asked to predict the future. But now, I think there’s more than enough value in being able to simply see the present clearly.”
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“Since 2010, Central Bankers became active market participants,” said Lindsay Politi, PM for One River’s inflation-strategy. “Uneconomic market participants with infinite balance sheets, seeking to distort market mechanisms for pricing of risk,” she added. “These distortions spread into all financial markets. Most people treat this tightening cycle like so many in the past. They tell us how equities behaved the last 5 times the Fed hiked. But this easing cycle has no precedent and undoing something so unique will not resemble previous cycles.”
“To grasp the differentiation, consider the most glaring QE distortion – negative yielding debt,” continued Lindsay. “At peak, there was $18.4trln negative yielding debt in public markets. For context, in Q1/2008 the total of the entire residential US mortgage market was $14.7trln, from 2004-2007 there were $1.4trln CDOs issued, and the size of Lehman Brothers’ balance sheet was $640bln at the peak,” she said. “There is still $2.5trln in negative yielding debt, and we’ve just experienced the worst first quarter for bond returns in history.”
“At the end of Q1 2022, global central bank balance sheets had shrunk slightly to just under $31trln,” said Lindsay, keeping close tabs. “This $31trln is made up of securities bought at uneconomic prices with the goal of smoothing activity and encouraging investment. It ended up just distorting financial market prices,” she said. “EU GDP is $15trln, global GDP is $84trln. To return balance sheets to where they were in 2010 at the beginning of QE would mean a sale of $20trln in assets, or roughly equivalent to selling the entire $24trln in US annual GDP.”
“That wasn’t the intent of QE,” said Marcel Kasumovich, One River Head of Research, picking up where Lindsay left off. “Interest rates stuck at the zero lower boundary with downside economic risks left two options – break the glass on the lower boundary or use excess reserves to lower rates and encourage investment. It worked, just not in ways its architects expected. Investment surged in the longest duration assets – intellectual property where capital kept flowing. And investors extrapolated the benefits of IP far into the future.”
“Companies also borrowed aggressively in response to the decline in interest rates,” continued Marcel. “But the investment was financial, through share buyback programs – lifting US equity market values to more than 2x GDP, nearly twice the October 2007 highs. And while it is tempting to try and attribute this expansion in equity values to factors other than QE, it is not possible to know until we reverse the policy and observe how markets respond. That is clearly not to say we should adjust policy to get our answer, it is simply an observation.”
“A central bank balance sheet would ordinarily expand with demand for currency,” added Marcel. “What QE does is pull forward that expansion, distorting time. When QE stops, excess reserves decline with a rise in currency demand. In other words, QE front-loads expected future currency in circulation. With the Fed balance sheet now a mind-numbing 36% of GDP, it would take 17yrs at an average nominal growth rate of 4% to normalize the balance sheet to pre-pandemic levels without QT – another distortion embedded in financial markets.”