The liquidity cycle is turning



Tim Winstone, credit portfolio manager, discusses the effect of central banks on liquidity within fixed income markets and whether an unwinding of quantitative easing is a cause for concern.

The last few years have been a good time to be a borrower. Central banks have largely been on your side – dispensing a restorative medicine of low interest rates and supportive asset purchase schemes in a bid to keep financing costs low and economies ticking along. But is the liquidity cycle set to turn?
Since September 2008 when the US Federal Reserve first embarked on quantitative easing, the US Federal Reserve (Fed), the Bank of England, the European Central Bank (ECB) and the Bank of Japan had by mid-September 2018 pumped a combined US$11.7 trillion into the global economy though expanded balance sheets.
Technical support
A significant portion of this has been used to buy government bonds, helping to lower the risk-free rate and so encourage investors to invest in higher-yielding riskier assets and lower the cost of finance more broadly across the economy. More specific action included direct purchasing of corporate securities. One of the most prominent has been the ECB’s Corporate Sector Purchasing Programme (CSPP), which was announced on 10 March 2016, with purchases starting on 8 June 2016.
Given CSPP purchases have been contained to only euro-denominated senior investment grade non-bank bonds, the programme has caused these sections of the market to tighten significantly. However it has also had an effect on non-eligible parts of the market such as high yield bonds. For example, spreads on euro-denominated BB rated bonds tightened on the back of an influx of retail flows into this area as investment grade investors hunted for higher yields and better valuations relative to investment grade credit, reaching a low of 183 basis points in January 2018 as shown in Figure 1.
Figure 1: BB rated corporate bond spreads (basis points)
Source: Bloomberg, ICE BofAML BB Euro High Yield Index (HE10), 31 December 2015 to 20 September 2018
But how can we be sure that the tightening is not simply coincidental? The ECB itself conducted econometric analysis that controlled for other determinants of corporate spreads. It concluded that relative to the pre-CSPP period between 1 April 2015 and 9 March 2016, in the subsequent period between 10 March 2016 and the end of December 2017, the CSPP accounted for a decline in corporate spreads of, on average, 25 basis points for eligible bonds, 10 basis points for ineligible investment grade bonds and 20 basis points for all ineligible bonds.
Given this, it seems reasonable to assume that without purchases by the ECB and no replacement buyer, European investment grade credit spreads may widen and issuers may have a tougher time accessing the debt markets.
A double-edged sword
The presence of central banks in the market as buyers has been useful to borrowers and the wider market in supplying funds for bond issuers and generating demand, yet it has also denied investors a higher yield than they might otherwise have obtained. The counterfactual argument is that those issues might not have taken place had the borrower not been able to achieve an attractive yield.
It is clear that QE has encouraged issuers to enter primary markets. Most notably, there has been a rise in debut non-financial BBB rated issuers looking to capitalise on ECB largesse. Since the beginning of the ECB’s public sector purchase programme (PSPP) in March 2015, which predated the CSPP, the size of the BBB non-financial sector has grown from €450bn to €755bn, with around €200bn originating from debut issuers as shown in Figure 2.
Figure 2: Factors behind the increase in size of the Euro BBB non-financial market since the end of 2013 (EUR billion)
Source: BofA Merrill Lynch Global Research. Non-financial bonds only. 31 December 2013 to 30 June 2018. Fallen angels (bonds downgraded to sub-investment grade), Reverse Yankees (bonds issued by US companies in EUR)

Additionally, the programme is viewed as having contributed to freeing up bank balance sheet capacity as some issuers have shifted their funding away from bank loans and towards bond issuance through the capital markets. With the ECB set to halt further asset purchases at the end of 2018, should we be worried about another major central bank stepping back from further asset purchases and would the withdrawal of QE lead to a reversal of its benefits?
First mover advantage
It may or may not be instructive to look at the US. The US Federal Reserve (Fed) has taken the first move in actually reversing quantitative easing. Since September 2017, as bonds mature, it is no longer rolling this over into new purchases and is gradually shrinking its balance sheet. Interestingly, the impact on credit markets has been muted as the reduction in the Fed’s balance sheet has not corresponded with poor US high yield bond performance (see Figure 3).
Figure 3: Central bank net purchases and US high yield total return

Source: Bloomberg Intelligence, US high yield = ICE BofAML US High Yield Total Return in USD.  Figures beyond August 2018 are estimates and may vary.

However it is difficult to read too much into this relationship given that the period also coincided with President Trump’s tax cuts and fiscal expansion in the US, low supply over 2018 and a recent stabilisation in US high yield flows.
More telling may be events elsewhere. Fed tightening has contributed to a stronger US dollar, which together with LIBOR stress, has led to a surge in volatility. Problems have flared up in several emerging market countries and European sovereign risk has re-emerged in Italy and Eastern Europe. So far these shocks have not been systemic but the frequency of these risk events is no accident. It is a symptom of tightening liquidity combined with rich credit valuations.
Can markets survive the withdrawal of QE? That depends on whether the patient – the global economy – is now sufficiently strong to stand on its own without the medicine the central banks have been dispensing.

The next article in this series looks at potential shocks to corporate earnings.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

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