One of the main topics of the year is the central banks’ balance sheet unwind, and the potential effect it can have on asset prices. As JP Morgan (and other sell-side institutions) pointed out, if we look at the annualized monthly net bond flows, the top 4 central banks (Fed, ECB, BoE and BoJ) will switch to net sellers in October 2018 (here). BNP Paribas published an interesting chart lately of the weighted average 10-year G4 bond yield overlaid with the G4 monthly bond purchases (here); we can clearly see that the increase in the total purchases has helped to push overall 10Y yields on the downside since 2010, hence eased financial conditions and stimulated the refinancing activity. However, what will happen to LT yields now that the purchases are expected to fall in 2018?
Many market participants have argued that the constant increase in central banks’ balance sheet has levitated all asset classes, and particularly the stock market; therefore, one economic area we are watching closely during the unwind is the Euro zone. If we look back three years ago, when Mario Draghi announced the launch of the 60-billion Euro bond-buying program on January 22nd, 2015, the ECB balance sheet was totaling 2.15tr Euros and the equity market EuroStoxx50 was trading at 3,400. As of today, the central bank’s assets are north 2.3tr Euro (the ECB balance sheet surpassed the Fed’s one last summer and is now worth 4.5tr Euros), while the EuroStoxx50 Index is up a mere 200pts, currently trading at 3,600 (here). We can clearly notice that the ECB effect on European equities was non-existent. It looks like the European equity market has been a dead market over the past couple of years; the Eurostoxx 50 has been trading sideways within an 800-point range between 2,900 and 3,700 and sits at its 50% Fibonacci retracement from its mid-June-2007 peak to Feb-2009 trough.
Hence, we chose this week to overlay the yearly change in the ECB balance sheet’s total assets with the yearly change in the equity market (18-month lag). As you can see, the two times series have shown some co-movements since the Great Financial Crisis; a decrease in the ECB assets is usually associated with a negative YoY performance in the EuroStoxx50 18 months later. For instance, the ECB balance sheet yearly change switched from +60% in June 2012 to -24% in January 2014 amid early LTROs reimbursement by European banks. If we look at the lagged performance of the equity market, the yearly change in the EuroStoxx50 index went from +20% in the summer of 2012 to -18% in June 2014.
In October 2017, the ECB cut its bond-buying program to 30bn Euros a month starting January 2018 for a period of 9 months, and the market expects that the central bank will taper QE to final three months of the year. With the yearly change on the ECB assets starting its downward trend, our question is the following: will the growth and investment story in the Euro area offset the expected downturn in equities?
Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change (Source: Reuters Eikon)