It’s sobering to think that, after four years of the Federal Reserve “tapering” its QE program, and with a reduction in its balance sheet imminent, we may only now be witnessing the point of global “Peak QE”. Add the holdings of the Fed, the European Central Bank (ECB) and the Bank of Japan (BoJ) together and you get more than $13 trillion. Even as the Fed begins to withdraw, the ECB and the BoJ will likely continue to add to the world’s supply of liquidity. Nonetheless, this is an important turning point, and we are likely to pass it this quarter.
Another defining feature of markets this year has been their persistent low volatility. At the time of writing the CBOE Volatility Index (VIX) had closed below 10 six times during 2017. This caps a run of three to four years in which equity-market volatility has been lower than the volatility of long-dated U.S. Treasuries.
As long as realised volatility continues to be lower than that implied in options markets, and as long as the major central banks stand as the marginal buyer of financial assets, the market’s volatility structure can remain suppressed. This raises the question of just how disruptive the transition might be, from a world in which central bank balance sheets are expanding to a world in which they are contracting.
At Neuberger Berman’s recent quarterly Asset Allocation Committee meeting, one of the members of the Committee took a notably defensive turn in their voting from Q2 to Q3. Acknowledging that central bank liquidity was not about to disappear overnight, they nonetheless pointed to the extremity of the fast-approaching “Peak QE” moment, and warned that a mere change in momentum could flip investor sentiment, amplifying the market’s potential left-tail risk. With cumulative asset purchases for the first six months of 2017 dwarfing those of previous years, the Bank of Japan owning a tenth of the Nikkei 225 Index market capitalisation, and flows dominated by passive and systematic momentum strategies, this Committee member was bracing for sudden market moves.
This was not the committee’s consensus, however. Most Committee members were comfortable that initial Federal Reserve balance-sheet reductions would be modest, beginning a gradual, rather predictable three-year process. Given its low inflation forecasts, most of us felt that any tapering the European Central Bank announces this year would be conservative, with rate hikes still some way off. The Bank of Japan appears to lag still further behind.
There was some talk among the Committee members of a “Yellen-retirement short” as a nod to how well the Fed Chair has managed expectations compared with the “Taper Tantrum” of 2013; and a few warnings were sounded that balance-sheet tightening could coincide with a rancorous U.S. debt-ceiling debate in September; but overall the Committee’s outlook as we cross “Peak QE” is for a gradual, non-disruptive drift upwards in risk premia.
Erik Knutzen is CIO multi-asset class at Neuberger Berman and a member of the asset allocation committee