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Last week we showed how the size of the Federal Reserve’s balance sheet could be converted into basis point hikes or cuts. We concluded that the Fed’s bloated balance sheet, combined with a nominal funds rate of 0.75%, pushes the “accomodative funds rate” to -1.73%. Below we take our analysis one step further by examining global central bank balance sheets’ impact on bond and equity markets.
The chart below shows the cumulative size of the five largest central banks. Currently they total over $18 trillion, up from $8 trillion right before Lehman’s failure and $2 trillion in 2000.
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We constructed a “Generalized Additive Model” (GAM) using 90-day log returns of the five separate balance sheets above. Additionally, we included measures of global economic and inflation growth. These measures are constructed using indices comprised of major releases relative to one-year averages. In the end, we have seven variables. Further detail on the model’s construction can be found here.
Actual (gray) and estimated 90-day returns from our GAM model (green) for the Barclays Global Aggregate Bond Index are shown in the top panel. The second panel shows the amount of returns explained by economic and inflation growth. The third panel shows the contribution of each central bank’s balance sheet to returns. On the whole, this model explains 68% of the variation in global bond returns since 2009. Interestingly, central banks are the dominant variables, explaining 60% of the variation by themselves.
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How much have central banks influenced markets over and beyond economic and inflation growth? To a certain degree central bank stimulus is seemingly fungible. Therefore, the recent discussion of reducing the Federal Reserve’s balance sheet should stoke fears, especially if stimulus slows elsewhere.
Throughout this era of heavy-handed monetary stimulus bond returns have still moved along with economic and inflation growth. However, central bank stimulus has very likely dictated the magnitude of returns.
The chart below shows the same analysis for the MSCI World Stock Market Index. This model explains 60% of the variation in global equity returns since 2009. Again, central banks are the dominant variables explaining 47% of the variation by themselves. Recent increases in balance sheets across the BOE, ECB, and BOJ are the likely instigators of rising equities since late 2016.
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The reaction functions of each variable relative to global equity returns are shown below. The plots show how the model believes equity returns move relative to changes in each variable.
Namely, reductions in balance sheets by the BOJ and PBOC have had severe negative impacts on equities (see red arrows under BOJ and PBOC). Additionally, rising inflation, a major theme of ours, is also assumed to negatively impact equity returns. The Federal Reserve has yet to see its balance sheet reduced, therefore its true reaction function to balance sheet reduction is mostly unknown. We believe it is very possible the Federal Reserves could follow the likes of the BOJ and PBOC.
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Conclusion
Central bank balance sheets are a hot topic for good reason. Yellen’s testimony before Congress on Tuesday (Feb 14) will be closely watched. Reductions in balance sheets have had a negative impact on both global sovereigns and equities, explaining a greater amount of their returns over and beyond economic and inflation growth.