17th October 2017

Liquid High

$20 trillion quantitative easing has instilled in markets a tangible sense of self-confidence. And why not, that’s a lot of liquidity. In some senses a little like the self-confidence one acquires from consuming too much alcohol. I wonder, does it impair decision making in the same way? We won’t know I suspect until the punch bowl is taken away. As has been said here in the past, talk of tightening from central banks has largely fallen on deaf ears. Comparing the Fed Fund Futures to the FOMC dot plot is an apt illustration of the market’s confidence in the Fed’s willingness to tighten. Currently the December 2019 median dot plot depicts a Fed Funds target rate of 2.7% versus the 1.8% priced in by the Fed Fund Futures market.

In Europe, the ECB are a little further behind the curve. Realistic talk of scaling back the balance sheet has only surfaced in the last 6 months with speculation now coming on line regarding the size of the reduction. Nonetheless the ECB announcement due later this month on this subject is keenly awaited. In attempting to ascertain the potential fallout of ECB tapering, it is worth analysing the impact of the bond purchases to begin with. Unlike QE in the US, where Fed bond buying actually resulted in a rise in yields, the impact of ECB bond purchases directly resulted in a sustained drop in yields. Whilst the higher proportion of foreign owners in the US treasury market is likely a factor, it is clear that the ECB have been the only buyer in town for a long time. So what can this tell us about the prospect of quantitative tightening? If the Draghi inspired mini tantrum in June is any indication, our view is that tapering will see a meaningful rise in government yields. We don’t believe this will be limited to the Eurozone market, with a widening in US Treasury and gilt yields also likely in this scenario.  Related to the scaling back of ECB bond purchases, many of our readers will be familiar with our view on political risk. On this note recent events in Europe would seem to indicate populism remains very much alive – witness the AfD performance in the recent German election. To what extent the ECB are monitoring this situation remains to be seen. However the link between asset price inflation, growing inequality and the rise in anti-establishment political groups cannot be ignored indefinitely.

Away from Central Banks

Focusing on credit, the continued accommodative stance has supported more high-risk parts of the bond market. Dollar denominated emerging market issuance year-to-date has been the highest on record whilst in European high yield, the BAML European HY index reached its tightest level in 10 years. Financial bonds continue to be strong, and firms well capitalised. However, concerns have risen from the insurance and banking sector. Losses from hurricanes and other natural disasters this year present near term risks in the insurance sector whilst investment banks continue to battle year-on-year double digit declines in trading revenue.

So far this month, a noticeable trend has been the pro-active stance of both US and UK lenders to curb consumer lending in their respective countries. The first two US banks[1] to report Q3 results both increased provisions for consumer loan losses in anticipation of higher credit card losses. In the UK, more high street banks and building societies intend to curb their supply of credit to consumers over the next three months than at any time since the collapse of Lehman Brothers, according to the Bank of England[2]. In Europe, this quarter will be the last one before the introduction of MiFiD-II, after which the expectation is for increased transparency of trading and the separation of payment for research and execution, amongst other changes. While the general expectation is for risk assets to grind higher till the end of the year, we will be closely monitoring the Q3 earnings season, new issue sentiment and secondary credit spreads for signs of cracks ahead of potential quantitative tightening.

By Steven O’Hanlon

[1] JPM and Citi Q3

[2] The Times