August 29, 2015

Why QE4 Is Inevitable

Why have global markets reacted so violently to Chinese developments over the last two weeks? 
There is a strong case to be made that it is neither the sell-off in Chinese stocks nor weakness in the currency that matters the most. 
Instead, it is what is happening to China’s FX reserves and what this means for global liquidity. Starting in 2003, China engaged in an unprecedented reserve-accumulation exercise buying almost 4trio of foreign assets, or more than all of the Fed’s QE program’s combined (chart 1). The global impact was indeed equivalent to QE: the PBoC printed domestic money and used the liquidity to buy foreign bonds. Treasury yields stayed low, curves were flat, and people called it the “bond conundrum”.
Fast forward to today and the market is re-assessing the outlook for China’s “QE”. The sudden shift in currency policy has prompted a big shift in RMB expectations towards further weakness and correspondingly a huge rise in China capital outflows, estimated by some to be as much as 200bn USD this month alone. In response, the PBoC has been defending the renminbi, selling FX reserves and reducing its ownership of global fixed income assets. The PBoC’s actions are equivalent to an unwind of QE, or in other words Quantitative Tightening (QT).
What are the implications? For global risk assets, they are clearly negative –global liquidity is falling. For fixed income, the impact on nominal yields is ambivalent because private safe-haven demand for bonds may offset central bank selling. But real yields should move higher, inflation expectations lower, and there should be steepening pressure on curves. This is indeed how markets have responded over the last two weeks: as if the Fed has announced it is unwinding its balance sheet!

No comments:

Post a Comment