the size of the ECB’s balance sheet, these reductions have thus far been modest, relative to the total volume of liquidity pumped in during the pandemic. But it is only when one compares the Fed and ECB balance sheets in conjunction with those of the BoJ and PBoC over the past year that a clearer picture of what has really been happening in terms of the overall central bank liquidity backstop, as can be observed on the two charts opposite.


What this comparison serves to underline is just how significant the fluctuations in the BoJ’s balance sheet in H2 2022 and going into Q1 2022 have been, with the sharp drop in the latter half of Q3 coinciding with the slide in equity indices, and the rebound in Q4 clearly boosting equities. It was then however offset by the large ECB TLTRO redemption in December, even if the ECB moves since August to draw down government deposits effectively more than offset this, as those deposits move to private sector banks, in the same way as when the US Treasury reduces its balance at the Fed. To a certain extent, it also serves a reminder that as Euro area yields have turned positive, the persistent outflows during the negative rates are being reversed, and offering considerable support for the EUR.


But it also underlines a few other important factors. The vast overhang of central bank QE liquidity continues to be grist to the mill for short squeezes, even with the sharp rises in official rates, and even with the huge rise in government debt levels during the peak of the pandemic, the actual “free float” in government bonds remains severely impaired by central bank QE holdings, which is problematic in the post GFC where lending is collateralized. The Fed’s reverse repo facility has and continues to function as a major buffer to ensure the sort of seizures seen in September 2019 have not recurred, but it is unclear how much this may be interfering with monetary policy transmission in markets. But the evidence on that will probably become clearer much further down the line if the evidence from the 2018-2019 Fed balance sheet reduction exercise is anything to go by. While many individuals and businesses may not be feeling the squeeze from higher rates, having locked in rates on fixed term loans and mortgages


prior to the start of the rate hike cycle, this will become more of an issue if rates do remain at high level for a protracted period after the end of the hiking cycle, as central banks have suggested will be the case. Perhaps more poignant for credit markets is the question of whether the tightening of credit spreads in recent months, and a seemingly still voracious appetite for the typical start of year rush of new issuance has been down to Fed and other central bank pivot expectations, as well as the generally much more attractive level of yields after last year’s surge, or whether it is the ongoing lack of ‘free float’ in ‘risk free’ government bonds.


However, all of this pales into insignificance, when one considers how much additional QE has come from the BoJ as it continues to intervene to stop JGB yields breaching the upper band of its Yield Curve Control band at 0.50%, with estimates suggesting that the BoJ’s balance sheet has risen by some $600 Bln since the start of December, while the ECB and Fed balance sheets have declined by a combined $350 Bln. The problem is that its current


efforts to enforce Yield Curve Control only serve to make the bar to it raising rates and exiting QE (let alone contemplating balance sheet reduction) that much higher. But with the likes of automaker giants Toyota and Honda awarding pay increases of 5.0%, and Nintendo hiking salaries by an even larger 10%, the BoJ’s target of 3.0% wage growth being needed to tighten policy may be a good deal closer (consensus estimates for 2023 national wage growth are around 2.6%). BoJ governor nominee Ueda will face an enormous challenge in managing expectations of any change to BoJ policy, and the fall-out and ramifications in market terms would render the Fed and ECB’ rate hiking and balance sheet reduction rather moot. The simple point is that the noisy market debate around Fed, ECB and even BoE, BoC and RBA terminal rates cannot afford to ignore the impact of what happens in Japan and indeed China, and its implications for overall global liquidity.


Marc Ostwald E: marc.ostwald@admisi.com T: +44(0) 20 7716 8534


22 | ADMISI - The Ghost In The Machine | Q1 Edition 2023


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