The long-awaited unwinding of the Federal Reserve's balance sheet could be having negative consequences across markets, including recent US corporate debt weakness, elevated bank funding costs, volatile stock markets and a tumbling Hong Kong dollar. While some analysts and investors cite trade war and geopolitical concerns driving markets and imbalances between supply and demand hurting bonds, others see policies by the Fed, the Bank of Japan and the European Central Bank as the main culprits.
After the 2008 financial crisis, central banks bought record amounts of bonds, crowding out other investors who turned to higher-risk assets for returns. "Central bank purchases were forcing investors into markets where they wouldn't have been normally," said Matt King, global head of credit products strategy at Citigroup in London.
As rates rise and the Fed withdraws from quantitative easing while the BoJ and ECB reduce purchases, those trades are beginning to reverse. "These are exactly the sorts of episodes of volatility and market weakness that you have to expect significantly more of as the strong market technical that has been pushing everything upwards and volatility downwards over the last few years, namely global central bank liquidity, gradually gets withdrawn," King said.
Volatility has been widespread. The London interbank offered rate, Libor, which measures short-term bank funding costs, is the highest since 2008, hurt by Fed rate increases and weakness in short-dated bank debt. The average coupon of high grade corporate bonds issued this year is above those on maturing bonds. If this persists it will mark the first year that corporate funding costs have risen since 2009, according to JPMorgan.
Stocks have been volatile and the Dow Jones Industrial Average in February recorded the worst fall since 2011. The Hong Kong dollar this month tumbled to levels where the Hong Kong Monetary Authority needed to intervene, after higher US Libor rates drew buyers, offering more than 1 percent over the equivalent HIBOR rates in Hong Kong, the widest differential since January 2008.
"Rotation from QE winners to QE losers has begun," analysts including Michael Hartnett, Bank of America Merrill Lynch's chief investment strategist, said in a recent report. Those winners, they said, included stocks, US and European high-yield bonds and emerging markets, while the losers included cash, commodities, government bonds and volatility.