US investors need to keep a much closer eye on everything else

Here we go again. Last month, America’s S&P 500 rose 7 percent, ostensibly as investors began to believe (or hope) that lower inflation rates would slow the Federal Reserve’s rate hikes.

On Tuesday, however, US stock markets suffered their biggest drop in two months as strong economic data sparked a flurry of market talk over the prospect of further Fed tightening.

That dragged other indices lower and fueled disputes between those observers (like Morgan Stanley’s research team) who see January’s market euphoria as overdone and those (like Jim Cramer, the prominent anchor of bad money) who think it’s the market bears who are “denying”.

This debate will no doubt be on and on, especially as recent Fed minutes suggest that even US central bankers have not been entirely unanimous on the outlook. However, as investors obsessively await the next batch of economic data or the latest words from Fed Chair Jerome Powell, they also urgently need to keep their eyes peeled – to what is happening with the major central banks off America’s shores.

This is something US television luminaries and pundits don’t often do. No wonder American investors (and voters) are notoriously short-sighted, and journalists are trained to use hard economic and corporate news to explain market swings. But right now, this often-ignored global central bank money really matters, as something quite surprising — if not contradictory — is happening.

Most notably, since last spring the Federal Reserve has been trying to fight inflation by raising interest rates and switching from quantitative easing to quantitative tightening. The Fed’s balance sheet shrank from $8.96 trillion in April to $8.38 trillion today. This was initially mainly due to the decline in commercial banks’ reserves, but more recently as the Fed ran down securities.

Economic logic might suggest that this American QT should have created tighter financial conditions. However, this is not the case. An unexpected fold in recent months that has compounded the Fed’s policy challenge is that the Chicago Fed’s index of national financial conditions fell to minus 0.45, compared to minus 0.13 last September. (A more negative number represents more loosening.)

Why? One reason could be investors’ growth optimism. But a much more likely culprit, says Matt King, Citi’s global markets strategist, is cash flows from non-US central banks. Because while the Fed’s balance sheet is shrinking, the People’s Bank of China is pumping more liquidity into the system and the Bank of Japan is sticking to its so-called yield curve control policy.

Meanwhile, the behavior of the European Central Bank was somewhat unexpected. Like the Fed, the ECB has also hiked interest rates, and more will follow. But its balance sheet has increased slightly due to some mysterious shifts in government deposits.

The net result, Citi calculates, is that these three central banks combined have pumped nearly $1 trillion in additional liquidity into the global system since October (currency-adjusted). This more than offsets what the Fed has done. Call it an accidental anti-QT if you like.

And King believes that trillion-dollar surge helps explain January’s stock surge. His historical models show that over the last few years, “stocks are up 10 percent [in MSCI world and S&P]” for every $1 trillion in new liquidity provided by central banks.

Torsten Slok, chief economist at Apollo, agrees. “BoJ purchases of Japanese government bonds to keep yields low are now larger than Fed QT,” he says. “The result is that central banks are again adding liquidity to global financial markets, what [likely] contributed to the rally in equities and credit in January.”

If this analysis is correct (I think) it begs another trillion dollar question: will this anti-QT last and continue to support asset prices? King doesn’t think so and expects markets to soften this year. One reason is that the PBoC is unlikely to ease policy further as Chinese officials are reluctant to foment more housing bubbles. Another reason is that the BoJ will come under pressure to scale back its yield curve control policy when it changes governors in April.

But there are some very big jokers in the pack. The Fed could come under pressure to slow QT if there is a US debt ceiling crisis. Flows for commercial and government reserves could be even more surprising at the ECB and other central banks. Finally, economists like Raghuram Rajan have noted that QT has never been done on this scale before, and the installations surrounding the process are untested and unclear.

More importantly, no one knows if the BoJ will really have the courage to give up yield curve control as the man slated to be the next governor – Kazuo Ueda – has said remarkably little about QE lately. This is important for many asset classes. To cite just one example, higher interest rates in Japan could prompt its investors to reduce their holdings in non-Japanese fixed income securities, which in turn would affect US bond prices.

So the key point for American investors is this: Even if they watch inflation data, corporate earnings and Fed speeches at home, they need to watch what the likes of Ueda are doing. Maybe Cramer should host his next show from Tokyo or Beijing. US investors need to keep a much closer eye on everything else

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