Morgan Stanley | Quantifying the impact of central bank balance sheet’s liquidity on assets (the so-called balance channel portfolio) is difficult. And already tracing the impact of QE on asset prices is nearly impossible. That is why we are following up some clues. The first of these is the depreciation of the US dollar. The second is the fact that government bond yields do not rise in parallel with equity, despite the fact that breakeven inflation rates do. In the absence of absolute proof, here are some examples from the past:
- the negative impact the reduction of the Fed’s reserves in Q3’19 had on financial conditions
- the market reaction in Q4’19 when the Fed changed direction by injecting reserves and improving financial conditions.
- no one will forget the record liquidity injection during this year: by the end of the year the G10 central banks will have injected $4 Tr in government bond purchases alone.
This liquidity tsunami will continue in 2021: we estimate another $2.8 Tr of liquidity (counting just government bonds). To put it in context, this is more than double the liquidity that central banks injected in any previous year. However, this liquidity does not find its place in the financial markets immediately. In fact 2020 is an example of this as reflected in the $4.5 Tr that is currently deposited in monetary funds in the US. If the global economy exceeds expectations, this flow of liquidity will support higher risk assets. That means that the US dollar will likely continue to depreciate against the G10 and Emerging Markets currencies and that the safest asset of all (the Treasury) will suffer in this environment. Therefore, the biggest risk would be that central banks will signal a reduction in liquidity sooner than we expect or that macro expectations will not be met.