Perspective on Risk - July 17, 2022 (Unprecedented)
Central Bank Balance Sheet Retrenchment; Liquidity Driven Markets Update; Climate Change Is Also Unprecedented
Let’s be clear, we are now in the midst of the early stages of an environment none of us have ever experienced. Past history may be informative, or it may be misleading. We’ve talked about this before.
Liquidity is driven by central banks,” says Guilhem Savry, who works in cross-asset solutions at Swiss asset manager Unigestion. “Over the past 10 years there has been large liquidity in the US and everywhere else, and now investors know it’s finished. It’s over.1
Central Bank Balance Sheet Retrenchment
A number of commentators have begun to write about central bank balance sheet shrinkage. Katie Martin and Colby Smith authored The mystery of how quantitative tightening will affect markets in the FT, and Mohammed El-Erian and Liz Ann Sonders have tweeted a version of this chart from the FT.
Liz Ann Sonders’ chart includes the SNB.
But neither include the Chinese central bank.
There is about $27 trillion of outstanding US Treasury securities. The Federal Reserve’s $8.5 trillion balance sheet includes $5.4 trillion of Treasury securities and $2.5 trillion of agency securities.2 The Fed’s Treasury holdings represent about 20% of outstanding Treasury securities. The ECB and BoE each own just shy of 40 per cent of their government bonds, while the Bank of Japan, which is unique in having no intention of stopping its purchases, already owns nearly half of Tokyo’s outstanding government debt.3
The Fed has begun to allow securities to roll off its balance sheet, and by September the Fed will no longer reinvest proceeds of up to $60 billion in maturing Treasury securities and up to $35 billion in maturing agency mortgage-backed securities per month, for a total monthly balance sheet reduction of $95 billion, or about a 13% annual rate.
The Fed Board staff estimate that “reducing the size of the balance sheet by about $2.5 trillion over the next few years, as opposed to maintaining the size at its peak level, would be roughly equivalent to raising the policy rate a little more than 50 basis points on a sustained basis.4” The Atlanta Fed estimates that “a $2.2 trillion passive roll-off of nominal Treasury securities from the Federal Reserve's balance sheet over three years is equivalent to an increase of 29 basis points in the current federal funds rate at normal times, but 74 basis points during turbulent periods.5”
Let’s be clear, at least for now. the only central bank actually projecting to shrink their assets is the US Fed.
In Europe,
The Governing Council decided to end net asset purchases under its asset purchase programme (APP) as of 1 July 2022. The Governing Council intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it starts raising the key ECB interest rates and, in any case, for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance.
As concerns the pandemic emergency purchase programme (PEPP), the Governing Council intends to reinvest the principal payments from maturing securities purchased under the programme until at least the end of 2024.6
The European Central Bank resisted the temptation to start its rate-hiking cycle at Thursday’s governing council meeting. But stalling until the July 21 gathering makes it more likely that once the first quarter-point increase is out of the way, September’s decision will see a half-point move that will take the benchmark deposit rate positive for the first time in eight years.
Money markets are betting on 150 basis points of ECB rate hikes by year-end, which would entail two half-point and two quarter-point increases in the next four policy meetings.7
Liquidity Driven Markets Update
If you’ve followed along for a while, you know that I have asserted that excess liquidity is the primary driving force behind markets these days, and that the central bank retrenchment will have a material affect on wealth levels (more of this in a subsequent post that I am debating with a few of you).
Josh Younger, Managing Director and Global Head of ALM Research and Strategy at JPMorgan, was on Odd Lots and was asked about current inter-dealer Treasury market liquidity conditions.
[The on-screen central limit order book] on average during say the New York trading session … [is] … something like $150 million over long periods of time. Over the past 10 years, that's averaged something like $150 to $200 million.… in bad times that can go down to $5 to $10 [million]. That's what we had in 2020. Now it's probably around $40 or $50 million on average. Now this fluctuates a lot over the course of the trading day, but this is like if you were to close your eyes and then, you know, pick a time and look at it, you get something like $40 to $50 million to trade within three levels of the best price. So that's low.
… if this was August, 2011, it would be probably a similar number. If this was June or July of 2013, the taper tantrum, you get a similar number to that. March of 2010 was much lower. In November of 2008, it was much lower. So you know, it's been worse, but it's definitely not great out there.8
Here are some other observations of the early stages of this retrenchment:
But we haven’t yet seen equity market flows exhibit capitulation (which increases the likelihood that there is more pain ahead here).
This is playing through to firms cost of capital. Jurrien Timmer suggests the cost of equity capital is holding steady, while data suggest that the cost of debt is rising materially. Presumably, some of the Fed’s estimated cost of unwinding portfolio holdings will go directly to risk premia, exerting an upward bias. Again, this will increase defaults among weaker firms.
Climate Change Is Also Unprecedented
[I]t is increasingly likely that the world will overshoot our most ambitious climate target—limiting warming to 1.5 ˚C. We are living in a world that has already warmed by 1.2 ˚C, leaving a vanishingly small carbon margin to work with.9
Assessing the US Climate in June 2022
The average temperature of the contiguous U.S. in June was 70.7°F, which is 2.2°F above average, ranking 15th warmest in the 128-year record. Temperatures across much of the southern half of the Lower 48 as well as from the northern Plains to the Ohio Valley were above average.
June precipitation for the contiguous U.S. was 2.33 inches, 0.60 inch below average, tying with 1930 for 12th driest in the historical record. Precipitation was above average across portions of the Northwest and Southwest. Precipitation was below average in the Great Basin, from the central Rockies to the Great Lakes, across the Deep South and from the mid-Mississippi Valley to the Southeast.
Integrated across the state, precipitation across Alaska ranked driest on record for June and was 0.04 inch less than the previous record set in 1934.
There were nine billion-dollar weather and climate disasters identified during January-June, the fifth-highest disaster count in the 43-year record for this year-to-date period. These disasters consisted of eight severe storm events and one drought event.
The wildfire season continues as large fires burn across portions of the South and Southwest and have grown rapidly across Alaska. Across all 50 states, more than 3.9 million acres have burned from January 1 through June 30 — nearly 2.3 times the average for this time of year.
According to the June 28 U.S. Drought Monitor report, 47.7 percent of the contiguous U.S. was in drought. Due to monsoon rains, parts of the Southwest saw a reduction in extreme to exceptional drought, but drought conditions erupted and/or expanded across parts of the mid-Mississippi Valley and Southeast.Puerto Rico has been in drought for a record 81 consecutive weeks.
I’m sure you’ve seen the temperatures in Europe recently. NASA provided this update on global conditions: Heatwaves and Fires Scorch Europe, Africa, and Asia.
In June and July 2022, heatwaves struck Europe, North Africa, the Middle East, and Asia, as temperatures climbed above 40 degrees Celsius (104 degrees Fahrenheit) in places and broke many long-standing records.
Good time to recall this 2018 paper: Temperature and humidity based projections of a rapid rise in global heat stress exposure during the 21st century
As a result of global increases in both temperature and specific humidity, heat stress is projected to intensify throughout the 21st century. Some of the regions most susceptible to dangerous heat and humidity combinations are also among the most densely populated. Consequently, there is the potential for widespread exposure to wet bulb temperatures that approach and in some cases exceed postulated theoretical limits of human tolerance by mid- to late-century. We project that by 2080 the relative frequency of present-day extreme wet bulb temperature events could rise by a factor of 100–250 (approximately double the frequency change projected for temperature alone) in the tropics and parts of the mid-latitudes, areas which are projected to contain approximately half the world's population. In addition, population exposure to wet bulb temperatures that exceed recent deadly heat waves may increase by a factor of five to ten, with 150–750 million person-days of exposure to wet bulb temperatures above those seen in today's most severe heat waves by 2070–2080. Under RCP 8.5, exposure to wet bulb temperatures above 35 °C—the theoretical limit for human tolerance—could exceed a million person-days per year by 2080.10
The National Weather Service has an interactive Wet-Bulb Temperature map for the US. Meteologix has wet bult temperature forecasts globally.
As a reminder:
A sustained wet-bulb temperature exceeding 35 °C (95 °F) is likely to be fatal even to fit and healthy people, unclothed in the shade next to a fan; at this temperature human bodies switch from shedding heat to the environment, to gaining heat from it.
It will get worse, EXPONENTIALLY.
Martin and Smith, The mystery of how quantitative tightening will affect markets (FT)
Martin and Smith, The mystery of how quantitative tightening will affect markets (FT)
Crawley, Gagnon, Hebden, and Trevino, Substitutability between Balance Sheet Reductions and Policy Rate Hikes: Some Illustrations and a Discussion, Board of Governors of the Federal Reserve
Wei, How Many Rate Hikes Does Quantitative Tightening Equal?, FRB-Atlanta
Monetary policy decisions, European Central Bank
Ashworth, ECB Delay Presages Bigger Rate Increases in Coming Months, Bloomberg
Hausfatherarchive and Flegalarchive, We need to draw down carbon—not just stop emitting it ,MIT Technology Review
Coffel. Horton, de Sherbinin, Temperature and humidity based projections of a rapid rise in global heat stress exposure during the 21st century, Environmental Research Letters