The Fed unleashed a coming market inflection with the onset of normalization. In our global fiat system, as long as the dollar remains the world’s reserve currency, the Fed forces global central banks to adopt its policy. A Fed balance sheet unwind, while other central banks continue QE liquidity creation, is causing turmoil in FX trading and disrupting perpetually tenuous, fiat-based trade agreements. Other global CBs will have to end QE and start unwinding their balance sheets. When the Fed announced normalization, in June 2017, I wrote:
The PBOC links the renminbi to the dollar (with occasional, minor re-pegs), so it will directly import the Fed’s balance sheet reduction. The ECB and BOJ are still expanding their balance sheets at the combined rate of $200 billion a month. Something among central banks will have to give if the Fed begins reducing its balance sheet. The dollar, as the world’s reserve currency, drives international monetary policy in a fiat world.
This process has started. Since October 2017 the Fed has shrunk its balance sheet by $40 billion and is increasing the pace of its reduction. The ECB has cut its QE in half and announced plans to end its QE in the second half of 2018. The BOJ’s balance sheet actually contracted in December 2017. However, the BOJ has gone so far down the liquidity rabbit hole that, without severe disruption, it is impossible to see how the BOJ can normalize its balance sheet.
Post-2008 financial crisis QE asset purchases and the corresponding tripling in size of CB balance sheets drove interest rates toward the zero bound. Indeed, for the first time in 5000 years, negative interest rates emerged as a global phenomenon, an unfathomable outlier that is strangely accepted as a new normal. Last year, $13.4 trillion of global debt returned sub-zero yields. Global debt increased in lockstep with the liquidity flood and manipulation of interest rates. Since the financial crisis in 2008, central banks have purhased, with money created out of thin air, $13 trillion of sovereign debt, corporate debt, mortgage securities, and market equities. In our CB commanded interest rate world, European junk bonds yield less than 10Y US treasuries. Reducing liquidity will result in an unwind of manipulated interest rates and a return toward natural, market set levels. Interest rates are already rising with the first minor step of Fed normalization.
Market volatility will accelerate along with the programmed increase in CB balance sheet reduction. It is unlikely that the Fed will proceed very far into its multiyear planned balance sheet reduction. A significant correction will cause central banks to return to the only arrow in their intellectual quiver: printing money.