End of the easy money brings a $410 billion global financial shock
The global shift away from easy money is poised to accelerate as a pandemic bond-buying blitz by central banks swings into reverse, threatening another shock to the world’s economies and financial markets. Bloomberg Economics estimates that policy makers in the Group of Seven countries (G7) will shrink their balance sheets by about $410 billion in the remainder of 2022. It is a stark turnaround from last year, when they added $2.8 trillion — taking the total expansion to more than $8 trillion since Covid-19 arrived.
That wave of monetary support helped prop up economies and asset prices through a pandemic slump. Central banks are pulling it back — belatedly, in the view of some critics — as inflation soars to multi-decade highs. The dual impact of shrinking balance sheets and higher interest rates adds up to an unprecedented challenge for a global economy already hit by China’s new Covid lockdowns, supply-side issues, Russia’s invasion of Ukraine and an unstable world where geopolitical risk premia are rising (see the chart).
Unlike previous tightening cycles when the U.S. Federal Reserve (Fed) was alone in shrinking its balance sheet, this time others are expected to do likewise. Their new policy, known as quantitative tightening — the opposite of the quantitative easing that central banks turned to during the pandemic and the Great Recession — will likely send borrowing costs higher and dry up liquidity. Already, rising bond yields, falling share prices and the stronger U.S. dollar are tightening financial conditions — even before the Fed’s push to raise interest rates gets into full swing (see the chart). This is a major financial shock for the world as the IMF sees growth in 2022 and 2023 (3.2% and 2.9%) lower than it did in January (4.5% and 3.9%)!
The Fed has already raised rates by 2% since the beginning of the year and markets are seeing about 1-1.5% of tightening between now and year’s end. Officials are also expected to start trimming the balance sheet at a maximum pace of $95 billion a month. The Fed’s pace of balance sheet unwind is expected to be roughly twice as fast as in 2017, when it last ran down its holdings. The magnitude of that contraction and its expected trajectory are a first in the history of monetary policies. The U.S. central bank will achieve this by letting its holdings of government bonds and mortgage-backed securities mature, rather than actively selling the assets it bought. Policy makers have left open the option that they might, at a later stage, sell mortgage bonds and return to an all-Treasuries portfolio.
In 2013, the Fed’s balance-sheet plans caught investors by surprise and triggered an episode of financial turmoil that became known as the “taper tantrum” with a very sharp rise in bond yields (+1.5% for US 10-year sovereign bonds). This time around, the policy has been well telegraphed, in the U.S. and elsewhere. Asset managers have had time to price in the effects, which should make a wrenching shock on the bond market less likely. So far, the Fed’s proposed runoff has led investors to demand a cushion for risks of owning long-term U.S. Treasuries: the 10-year yield has jumped by 1.5% to 3.5% between January and mid-June 2022. As a result, bonds have strongly underperformed: investment-grade bonds (issued by government and corporate) have lost 8.4% (in euro) during the period, their biggest drop since at least 1999! But since mid-June, the yield that investors require to own longer-maturity debt has decreased to 2.5% and investment-grade bonds have generated a positive return (+7%) as many investors now fear that central bank monetary tightening will lead to an economic recession. Nevertheless, it remains a historically awful year for bonds even if they have halved their underperformance versus stocks to -4% (in euro). Inflation fears are receding, but only because of confidence that the economic slowdown will be so drastic that it will extinguish pricing pressure!
As liquidity is drained from bond markets that have been flooded with central-bank money over a period that stretches back to the 2008 financial crisis, some investors are paring back on risk assets in anticipation. Over the past weeks they have bought sovereign bonds and cut back on their holdings of high yield bonds, credits, and emerging market hard-currency bonds as they expect the economy to slow down or even head into a recession this year. For our part, we think that it is a good time to start buying some good quality bonds as a safety hedge in case stocks react badly to quantitative tightening and higher interest rates. Risk assets tend to do worse when the economy really tanks, and earnings are cut. That is preceded by higher rates. On that timeline we are not there yet. But adding fixed income slowly as yields go higher will eventually give a more efficient hedge in a multi-asset portfolio when and if equity returns do turn more negative.
- The multi-year market mantra of TINA - the idea that There is No Alternative to equities – is indeed facing a major threat as stocks don’t look terribly attractive versus bonds. The dividend yield advantage of stocks against bonds is falling fast (0.3% versus about 1% at the beginning of the year) as yields on sovereign bonds average now 1.9%, i.e. nearly the same level than the forward dividend yield for stocks (see the chart).
- The percentage of S&P 500 index members with a dividend yield higher that the current 10-year US Treasury yield has fallen to the lowest level since 2007 (11% versus 45% last year and more than 60% in 2020). Corporate payouts are under pressure as companies grapple with fears of recession, historically high inflation and supply constraints!
- And the way investors are embracing that narrative grows clear from the sharp decline in bond yields: The U.S 10-year yield has decreased from 3.5% to 2.5% since mid-June! The latest survey of international money managers by Absolute Research asks respondents to estimate the probability of various outcomes and shows that “TINA” is more or less at an end. Stocks usually outperform bonds over a given 12-month period; but now, only 53% of money managers believe that they will do so over the next year. That is the lowest figure since the survey started in 2015!