Do you have too much money? Are you losing sleep over that skyrocketing bank account? Maybe not. But think of Jerome Powell and Christine Lagarde, who must all get us out of a global monetary glut. Faced with essentially the same problem of the pandemic era, the Federal Reserve and the European Central Bank came to the same solution: drastically reducing net monthly asset purchases. Unfortunately for the financial markets, they will retreat at the same time, making 2022 the year of the “tandem tap”, the fastest cash drain in a decade.
Monetary data indicates that advanced economies are inundated with cash, thanks to the voracious purchase of financial assets by central banks. In March 2020, amid the financial panic over Covid-19, the New York Fed was creating money to buy up to $ 75 billion in assets every day. Around the same time, the ECB announced an emergency program targeting 1.85 trillion euros ($ 2.15 trillion) in total purchases. Plentiful liquidity helped governments, businesses and households survive the lockdowns. Cash flow collapsed but bankruptcies barely increased. Asset markets and the real economy came out of the crisis on a solid footing.
The Covid public health crisis appears to be easing, but the cash injection has never stopped. The two central banks still buy around $ 235 billion in assets each month between them. Because neither the US nor the EU has capital controls, this extra liquidity flows freely across borders, flooding markets everywhere. For global liquidity, it doesn’t matter which of the two central banks is buying.
The result has been a feverish rebound in almost all assets, removing lending rates, inflating stock prices and even creating assets where none existed. The financial system must invent new types of assets because there are not enough to absorb the deluge of liquidity from central banks. Over 6,000 cryptocurrencies are now traded, not to mention non-fungible tokens, which are said to establish ownership of easy-to-copy digital artwork.
With the resumption of inflation, central banks are curbing purchases. The ECB has already started, announcing a move towards a “moderately slower pace of net asset purchases”. The Fed essentially promised to do so this quarter, warning markets that “a moderation in the pace of asset purchases may soon be warranted.”
In two ways, the key term here is “moderate”. First, it reveals the fear of banks that the markets will react too sharply to the policy change. Second, it is wrong. The combined net purchases of the two banks are expected to drop from the current pace of about $ 235 billion per month to zero in 12 months, a deceleration of about $ 20 billion per month.
The last time net buying was reduced in the United States, triggering the “taper tantrum” of 2013-14, the Fed’s decelerating pace was $ 8.5 billion per month over 10 months. But at the time, the ECB was preparing to launch its own purchases, providing a counterweight to the markets. When the ECB set up its own taper in March 2017, it took 21 months to complete, decreasing net purchases by an average of 3.9 billion euros per month. The pace of the snail – and the resumption of net asset purchases by the ECB 11 months later – helped offset net sales of securities by the Fed.
In these two episodes, the two central banks compensated for each other, mitigating the aggregate effect. This time, however, the two banks are expected to decline in tandem, amplifying the effect on cash flow. This should terrify investors. Recent pioneering research by Xavier Gabaix and Ralph Koijen shows that flows don’t just shift asset prices; they disproportionately displace them. One dollar added to the stock market can increase the overall market valuation up to $ 5. A dollar subtracted can have the opposite effect, lowering the overall valuation by $ 5.
No flow is greater or more predictable than a major central bank’s purchasing program. As the world’s two major central banks prepare to turn off the taps, financial markets are warned. Frontier assets such as NFTs are likely to be the first to fall, but experience suggests that no asset class is immune to a liquidity drought. As the tandem unfolds, investors and asset managers will need all the downside protection they can get.
Mr. Valatsas is Chief Economist at Greenmantle, a macroeconomic and geopolitical consultancy firm.
Copyright © 2021 Dow Jones & Company, Inc. All rights reserved. 87990cbe856818d5eddac44c7b1cdeb8