Balance Sheet Reduction, Who Else Will Join the Chorus?

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The great unknown is when other central banks will join the chorus. Hawkish rhetoric is on the rise outside U.S. borders. But, action speaks louder than words…

The direction of equity returns have remained dictated by economic growth, however insulation to negative developments and a positive beta to positive developments have very likely been provided by continued monetary stimulus across the globe.

What if economic and inflation growth were allowed to mechanically determine the impending unwind of Fed, ECB, BoJ, and PBoC balance sheets?

The chart below shows forecasts for 2018 through 2019 based on major economic and inflation data releases.

Quick takeaways:

Eurozone’s recent economic improvements suggest a much lower balance sheet by the end of 2019 near $3.05T
US’ slower pace of gains points to a modest $0.88T reduction over the same time frame
Continued lack of inflation in Japan indicates the BoJ’s balance sheet could continue rising toward $5.13T
PBoC is expected to maintain a stable balance sheet near $4.88T

The next chart shows the same forecasts, however stacked to indicate totals across the big four central banks. Total balance sheet assets are expected to drop from a current $19.1T to $16.6T by November 2019. In reality, a drop of $2.5T is quite marginal. Investors seemingly understand the process of ‘normalization’ will be a long one, especially in the event a recession were to hit in the coming five years.

What could make this change? Easy, inflation.

Core inflation remains a laggard across most economies. Only Sweden appears primed to become a first-mover for economies dealing with negative interest rates. The chart below shows OECD composite leading indicators versus CPI less food and energy YoY through July 2017. Sweden’s central bank is nearly alone in the upper right quadrant meaning they are dealing with inflation above target while their economy is expected to continue growing.

Sovereign yields have become increasingly attached to changes in total assets held by the big four central banks. The scatterplots below show 60-day log changes in total assets versus returns for U.S. and German 10 year sovereigns since 2016.

A continued rise in the BoJ’s balance sheet will likely be washed out by a reduction by the Fed. What Draghi decides for the ECB is likely most important for yields going forward. An ECB reducing assets alongside the Fed in 2018 would bring down total assets held by the big four central banks and finally drive yields higher.