It is hardly a secret, that one of the biggest threats facing risk assets in 2018 and onward, is the great central bank QE/balance sheet unwind, something we have discussed extensively in the past year, and as a recent example, in “This Is Most Worrying”: In One Year, Central Bank Liquidity Will Collapse From $ 2 Trillion To Zero,” in which Deutsche Bank said that “the most likely causes of a shift to ‘flight mode’ and a rise in volatility” is that by the end of next year, the combined expansion of all the major Central Bank balance sheets will have collapsed from a 12 month growth rate of $ 2 trillion per annum to zero.“
This is shown in the following chart depicting the total shrinkage in central bank asset growth:
And yet, despite the Fed’s methodical if slow, balance sheet shrinkage and the ECB’s recent QE tapering from €60 to €30BN per month, followed by the BOJ’s latest “stealth tapering” last week, stocks have started off the new year with a panicked melt-up euphoria the likes of which haven’t been seen in decades, as the flurry of serious headlines suggests.
The term of the week is ‘melt-up’ pic.twitter.com/6phpDc47uW
— Mark Constantine (@vexmark) January 12, 2018
How does one reconcile this historic stock surge at a time of shrinking central bank balance sheets?
The answer comes from Citigroup’s credit research team, which points out something most central bank unwind projections have missed, namely that while risk assets on central bank balance sheets may indeed be shrinking, other reserve managers are going in the other direction.
According to Citi’s analysts, the answer is that although both the Fed and ECB are scaling back their balance sheets, the increase in EM FX reserves recently, with Chinese FX reserves doing the majority of the heavy lifting, has largely offset all of this. This is highlighted in the left-hand chart below. In fact, as the right-hand chart shows, on a rolling 3 month basis FX reserve purchases by EMs have largely offset all of the implied downward risk impulse from the past year.
As a reminder, last week China reported that its foreign-exchange reserves posted an 11th straight monthly increase, capping a year of recovery amid tighter capital controls, a stronger yuan and resilient economic growth (even if as Goldman calculated much of the reserve increase has been due to valuation effects). At the end of 2017, Chinese reserves climbed by $ 20.7 billion in December to $ 3.14 trillion, bringing the full-year increase to $ 129 billion.
Somewhat coincidentally, the theory that China may be goosing the markets was proposed last week by a different group of Citi analysts, who proposed that “it looks like the PBoC has been adding quite a lot of liquidity in the shorter end of the curve in recent days -with a variety of interbank rates softer, and the 1y CGB yield notably lower by 21bps YTD whereas 5s and 10s yields have stayed broadly flat.”
As we said last week, “assuming that Citi is correct, it would explain many things, not least of all the stunning surge higher in Chinese, global and even US stocks.” Here is Citi’s own “conspiratorial” take:
“Against that background, it is no surprise that equity markets have been so well supported and the SHPROP has exploded upward.”
In other words, just like China’s aggressive policy change after the Shanghai Accord of February 2016 unleashed a record 21 of 22 positive months for the S&P…
S&P is up 21 of the past 22 months, starting with the Shanghai Accord in Feb 2016 pic.twitter.com/LOngt5A4ba
— zerohedge (@zerohedge) December 29, 2017
… so it again appears to be China’s stealthy asset purchases across global capital markets that has resulted in the market melt-up observed in the end of 2017 and start of 2018.
Of course, in light of recent vocal warnings from China that its Treasury purchases may be discontinued soon, extrapolating China’s generous intervention in risk assets for the foreseeable future would be dangerous. Meanwhile, even as Beijing may flip and halt accumulating reserves, one thing is certain – at least for now – that central banks will keep on unwinding their balance sheets. Here’s Citi once more:
given that this aggregate central bank liquidity measure has had a significant degree of correlation with risk asset performance over the past few years, we are if anything reaffirmed in our cautious stance on 2018 as a whole. Even if EM FX reserves were to continue accumulating at close to their current rate, that would be outweighed by the almost $ 1 trillion reduction in DM central bank balance purchases due to occur this year.
Citi’s concludes by appropriately wrapping up the balance sheet unwind narrative in the story about the frog – stuck in boiling water – that did not realize how hot the water was until it was too late:
As the old parable goes, a frog that has the misfortune to find itself in a pot of boiling water will generally have the sense to jump straight back out. But if the water is initially tepid and subsequently brought to boil slowly, the frog won’t realise what’s happening until it’s too late.
* * *
The announced trajectories of the major central bank balance sheets indicate that the level of aggregate net asset purchases will reach its 2018 lows in the latter part of the year. But while we may only reach boiling point then, we’re already heating up: the delta in tapering is currently very large, with the Fed increasing its pace of net selling and the ECB having halved its net purchase volumes already.
Citi’s punchline: “the frog may end up getting cooked well before boiling point.” For now, however, the market’s daily record highs make a mockery of any warning, and any references to frogs stuck in boiling water are promptly deflected with tantalizing images of massaging bubbles and “nice warm Jacuzzis.”