Quantitative tightening and its impacts on asset markets

Asset prices have rallied in recent months, especially global stocks have risen by 5.3%.

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Asset prices have rallied in recent months and the US dollar has fallen. Global bond returns, for instance, have amounted to about 2.8% over the past three months, global stocks have risen by 5.3% and the dollar’s DXY index is down by just over 2% but has been down a good deal more at its lowest point. These might not seem like huge moves, but they are notable given the weakness we saw for asset prices and strength for the dollar through the first three quarters of 2022. Why the turnaround?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said the said fact is due to many factors such as the sharp fall in European gas prices, falling inflation and more. But there’s also another argument and this one might not bode as well for those hoping that these trends of rising asset prices and a weakening dollar can persist over the long-term.

This alternative argument for asset price strength is that it is little more than a consequence of a short-term surge in central bank-generated liquidity. Now this might seem like an odd claim. After all, the Fed has been raising rates and reducing its balance sheet at a pace now that is close to USD100bn per month. The Bank of England has started to sell gilts as it unwinds QE and the ECB will soon start to reduce its own asset pile starting in March. However, in Mr. Steve Barrow’s view, there’s two points to make here.

The first is that central banks have all tried to introduce quantitative tightening in a way that does not fluster asset markets. As Fed Chair Powell and others argue, quantitative tightening is designed to be something that quietly goes on in the background; not something that is suddenly unleashed with a fervor that undermines asset prices.

The second point is that all of the "surprise" in terms of expanding central bank liquidity has come from other central banks, most notably the PBOC and BoJ. But rather than a rapid and surprising tightening of liquidity conditions, it has been the other way around, as the pair have flooded the markets with cash, albeit for very different reasons. The PBOC has not just stumped up the cash it normally does in the Lunar New Year holiday period, but bolstered this significantly to accommodate, and even encourage, the economic rebound that is coming from the rapid easing of pandemic restrictions.

For the BoJ, the issue has not spurred growth but, instead, stopped the bond market vigilantes from pushing 10-year JGB yields above the new 0.5% upper limit . This too has led to a surge in liquidity as the BoJ has aggressively stepped up its JGB purchases.

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The argument is that all this new cash that’s sloshing around has been put to work in asset markets, helping to generate the much better performance that we’ve seen in recent months. Now, clearly, we can’t tell if this is true or not. We do know that liquidity has expanded for these banks, but we can’t tell if this is the reason why asset prices have rallied. If it is at least a contributing factor, it could be a worry for the future as neither source of liquidity seems set to persist into the long haul.

The PBOC will eventually accommodate the increase in activity in the economy that it wants, and the BoJ will eventually end its yield curve control policy and allow 10-year JGB yields to trade wherever they want. When we consider the creeping quantitative tightening from other central banks, it appears that central bank liquidity provision will not be the fuel for asset markets that bulls may have hoped for.

However, Mr. Steve Barrow doesn’t think that all is lost. In fact, if central banks do push ahead with quantitative tightening over time, it is likely to be because economies prove reasonably robust and are hence able to cope with the fact that the banks are taking the punch bowl away. In other words, the need for central bank liquidity to prop up asset markets should diminish over the long haul as economic recovery develops and inflation comes down. Now, this certainly does not mean that we are screaming bulls about asset prices. Instead, he thinks it will be a struggle this year, with bonds and stocks barely in the positive column come the end of the year.