Hopes are European Central Bank would extend its asset buying campaign at a policy meeting later in the session
THE long road from financial crisis to recovery passed another milestone in September when the US Federal Reserve (Fed) announced that it would start to reduce its $4.5 trillion balance sheet from October.
The process will start slowly with an initial $10 billion of Treasuries and mortgage backed securities (MBS) being allowed to run off per month.
However this will step up by $10 bn every three months until it reaches a cap of $50 bn per month.
At this point the actual pace of balance sheet reduction will depend on the flow of maturing bonds, but it will mark a meaningful change in liquidity.
The move toward quantitative tightening (QT) has begun.
In a world of efficient markets the shift from QE to QT would have minimal effect as it would be fully anticipated by markets and so already priced in.
Mindful of this, the Fed has been fully transparent in their intentions by detailing the balance sheet reduction process back in June. No one should have been surprised by the announcement on Sept 20.
Will global liquidity continue to expand?
Whilst the Fed has reached an historic milestone, central banks elsewhere are lagging behind with the Bank of Japan (BoJ), European Central Bank (ECB) and Riksbank still fully engaged in QE.
We estimate that central banks have injected $1.5 trillion of liquidity through asset purchases over the past year led by the BoJ and ECB.
Although the global liquidity is still growing, the pace of growth will decelerate such that by the end of next year it will be rising at half its current rate and will almost grind to a halt in 2019.
Although the BoJ is expected to continue with asset purchases over this period as it tries to hit its inflation target, increasing QT from the Fed and tapering of QE by the ECB causes a slowing in global liquidity.
In many respects the ECB move may prove to be the more important development in 2018. The ECB’s programme has been larger as a share of GDP and domestic markets than that of the Fed’s.
As a result we have seen a considerable squeeze on Eurozone sovereign bond markets where the ECB has bought a large proportion of available bonds.
As the ECB tapers QE we might expect a rise in yields across the Eurozone, thus bringing investors back to their domestic bond markets and resulting in a reversal of previous flows.
Keioth Wade is the chief economist and strategist at Schroders
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