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Global monetary policy has been a multi-trillion dollar relay race over the past decade. But in 2018, there will be no one to pick up the baton, setting up a potentially anxious year for the world’s bond markets.
That is a sharp contrast to recent years. When the Federal Reserve began to unwind its bond-buying programme, the Bank of Japan cranked up its even grander quantitative easing scheme. By the time the Fed started raising interest rates, the European Central Bank had unveiled its own monetary bazooka, quelling the ructions that many feared were inevitable.
The coming year promises to be an inflection point for central banks. The Fed has started reducing the pile of the bonds it acquired after the financial crisis — a process that will accelerate. The ECB started to trim its QE programme in 2017 and is expected to end it altogether in 2018. Even the BoJ is expected to raise its bond yield target slightly next year.
While markets thus far appear sanguine about the prospects, investors are eyeing the possible effects with rising trepidation. While it has not done it single-handedly, central bank support has been instrumental in levitating markets higher since the financial crisis.
“The coming changes in global monetary policy is nowhere near priced in and is actually grossly underestimated,” says Robert Michele, chief investment officer of JPMorgan Asset Management.
US bank Wells Fargo estimates that central banks have absorbed more than all the bonds issued by G10 governments over the past two years but next year they will only buy 40 per cent of overall debt issuance.
This adds up to a large demand shortfall that will have to be filled. Man GLG estimates that central banks have globally swelled the size of their balance sheets by about $15tn since 2008 with the Fed, the ECB and the BoJ accounting for most of it.
But the hedge fund estimates that they will be buying $3tn fewer bonds in 2018 than they have last year. Mr Michele reckons that, by the autumn, the size of central bank balance sheets will finally shift from expanding to contracting.
“In the past there was always another central bank that would step up and pick up the baton from someone scaling back,” says Pierre-Henri Flamand, chief investment officer at Man GLG. “No one really knows what will happen when there’s no one there.”
Analysts have started to sketch out what they think the impact will be and from their annual outlooks it is clear that most expect bond yields to climb noticeably — albeit not violently — as a result of less accommodative monetary policy.
The mean estimate for analysts surveyed by Bloomberg is that the 10-year US Treasury yield will climb from 2.44 per cent today to 2.90 per cent by the end of the year. Strategists expect the equivalent German Bund yield to rise from 0.45 per cent to 0.9 per cent, the 10-year UK gilt yield climbing from 1.26 per cent to 1.70 per cent and the Japanese 10-year yield nudging up from 0.05 per cent to 0.10 per cent.
Some are more worried, however. Torsten Slok, chief international economist at Deutsche Bank, is particularly concerned about the effect of the end of European QE, arguing that the ECB’s exit from bond markets is the single biggest risk facing global markets in 2018, given how the eurozone’s bond purchases have sent money sloshing everywhere.
“As the ECB slows and ultimately ends QE in 2018, the amount of cash flowing to risky assets such as credit and equities will slow down and ultimately dry up altogether,” Mr Slok says.
He reckons that, at the end of 2018, the 10-year Bund, gilt and Treasury yields will be at 1 per cent, 2 per cent and 3 per cent, respectively.
Of course, gloomy forecasts of tighter monetary policy taking a sledgehammer to a multi-decade bond bull market are nothing new. Indeed, they have become as predictable as they have been wrong in recent years.
There has been the occasional tremor, such as a brief eurozone bond sell-off in June after investors turned skittish at some comments made by ECB president Mario Draghi. But for the most part markets have shrugged off the prospect of central banks draining the market punchbowl — and it is unclear why that would change.
In part, this is due to the sheer scale of the monetary accommodation. Rather than a punchbowl, central banks have over the past decade served up something closer to a lake and taking away a few barrels might not make much of a difference.
Estimating the impact the withdrawal of central banks will have is therefore tricky but Mr Flamand argues that analysts always underestimate the role of the marginal buyer in a market and what happens if they disappear.
“Yes, we know that central banks will do less next year but no one knows what the price should then be,” he says. “I think people will be shocked by the magnitude.”