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Central Bank Support – Too Big to Unwind?

The past decade has seen a consistent stream of supportive central bank actions from across the globe to prop up market conditions. Investors and fund managers are waiting, somewhat confused, for asset prices to reflect the hawkish tones central bank leaders are beginning to voice. On closer inspection, the group of central banks that includes the G4 & Swiss have made statements to indicate that they are likely to reduce liquidity injections from a run-rate of US$2.1trn in 2017 to closer to US$800bn in 2018 according to Dec 2017 research from Macquarie. There have also been suggestions of easing even turning negative in 2019.

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Meanwhile, the Fed has suggested there will be three rate hikes in 2018. However, bond yields and yield curves as a whole have shown little movement on this news.

In fact, markets are pricing in that central banks will be ineffective in raising the cost of capital. For example, the 10 year German Bund yields remain stuck around 30bps.

1 Liquidity and systemic pressures have moved sideways in the market and both the St Louis Fed Financial Stress Index and the ECB systemic stress index are currently trading at surprisingly comfortable levels. Spreads, even for low-grade credit, also remain low – pricing in little risk or impact from monetary tightening.

These dynamics lead us to wonder if central bank support itself has become “too big to fail” – or perhaps the current phenomenon could be more accurately characterized as being too big to unwind?

 

Supply Side Succour

Perhaps this is an outcome that has been a long time coming. Supply-side shocks from the 1980s onwards prompted continual central bank support- driving down the cost of capital. This provided the hoped-for outcomes of controlling inflation and stimulated growth. However, the monetary easing, in effect, created asset bubbles down the line due to the leverage lurking beneath the surface.

The GFC led to a doubling down on this approach – with central banks buying US$12trn of bonds (in the G4 plus Swiss region) against a GDP increase of only close to US$2trn.

1 While this further suppressed capital costs it only fuelled the search for yield – driving productivity lower and exacerbating inequality the world over.

This outcome is in line with renowned Swedish economist Knut Wicksell’s prediction from as far back as the 1890s – that keeping the cost of money below the ‘natural rate’ would inevitably create dangerous anomalies.

Is it too late for a Weaning Off of central bank support by G4 countries?

So, will see the end of financial suppression any time soon? Tied in with top level economic policy is of course social agenda. There are compromises to be made against political ideals. While many investors call for sharper action from central banks to counter inflationary pressures, there are few who welcome the commensurate downside impact that must inevitably materialise.

Central Banks can only defer and suppress the underlying market forces for so long. At some point the mean reversion we have been observing in bond market reactions to central bank actions will recede. Expect flattening yield curves to show more persistence into 2019 as central banks attempt to tighten monetary conditions.

Sources:

1Macquarie Research, Equities, 19th Dec 17, Slow burn default Mean reversion is not coming back.

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