Earlier today, we showed once again - this time with Citi's assistance - why the global credit impulse may be the most important variable for the global economy: as Matt King stated simply, "the change in the flow of credit drives GDP growth" and just as importantly, "the credit impulse also often correlates with asset prices."
Now, as a follow up to our earlier piece laying out the basis behind the global credit impulse, we present Citi's thoughts on what happens next, now that the impulse has turned negative.
We start with a key question: "with the impulse now negative, why are markets not weaker?" King's answer is two-fold: either the lag this time is longer than usual, or the market has simply lost its discounting ability (a point he touched on last week), or as he puts it now "some markets seem to be following a different beat", and cautions that "Some signs even the link to asset prices now weakening."
King's next observation is one we have made countless times: in a time of declining private credit creation (due to either lower demand or tighter supply), impulse creation is entire in the hands of the public sector, and thus central banks. In short: "markets are in thrall to central banks."
The next slide points out another familiar observation: the change in global central bank purchases (i.e. balance sheet expansion), which Citi calls "our favorite market indicator" correlates almost 1 to 1 with the change in risk prices. Which is why Citi's conclusion ahead of the Fed's balance sheet upcoming balance sheet unwind is a dire one:
"Expect markets to flounder as central banks try to exit."
Hardly the glowing message of endorsement Janet Yellen was looking for as the Fed prepares to unleash the biggest experiment in the history of the Fed. It may explain why Matt King is no longer invited to TBAC meetings.
Citi's next observation is one recently made by Bank of America: without the Fed buying and/or reinvesting, either yields will have to surge or equity prices will tumble, for the simple reason that $1 trillion in incremental net issuance is about to hit the market, and this time there will be no price indescriminate buyer to soak it up.
What follows is another troubling comment on market psychology, namely that the "Forced Buying" that has been engendered by the Fed over the past 8 years as everyone was forced into risk assets, is "buying without conviction." Which is also why "every time central banks scale back, investors head for the exit." This time will not be any different.
Market crash or "floundering" aside, Citi warns that as a result of the negative credit impulse, an almost assured outcome is that central banks will likely miss their inflation targets, again.
Which brings to what may well be the most important question for the current economic system:
"What happens if they eventually find they can't exit?"
One possible answer is, well, bad and involves gold, lead and canned foods.
Citi hopes that the answer is (hopefully) the other one: "welcome to Japan", a world where central banks can never exit and have to keep injecting liquidity in perpetuity (until they run out of things to buy) or risk complete collapse. In this scenario "Spreads likely to rebound when CBs are forced back in."
The final question: how to trade it. Here are some ideas:
- Markets trapped between multiple, very different, equilibria; transition between them may well be abrupt:
- Use liquid instruments to control portfolio risk; beware illiquid assets unless genuinely non-mark-to-market
- Near-term risk-reward on credit uncompelling, even though longer-term default risks probably limited
- Buy the dips when central banks are adding liquidity. Don’t buy them when they’re pulling back - as at present
- Synthetics to outperform vs cash as CB-induced supply shortage eases
- Do run tail-risk hedges, but look for low or zero-cost ones:
- Be long cheap sources of convexity, e.g. through barbells
King's parting warning: "Today’s credit impulse leads to tomorrow’s buyers’ remorse."