The unwinding of balance sheets by major central banks will soon begin to bite, causing a massive siphoning of liquidity from markets, hitting risk assets while driving bond yields and the dollar higher, according to BNP Paribas SA.
A 10% contraction in global liquidity would correspond to a 4% decline in stocks, an appreciation of at least 2% for the greenback and an initial jump of over 10 basis points for Treasury 10-year yields, the bank’s strategists said in a note.
Alongside rate-hiking, the Federal Reserve has been engaged in quantitative tightening for about a year and the European Central Bank stopped reinvesting the full proceeds of its asset purchases a few months ago. But a mix of factors, including the fact that the Treasury had to slash its cash buffer before Washington pushed through a debt-limit suspension, have prevented the typical drain of liquidity.
That’s all changing now, the bank’s strategists said.
These types of contractions impact assets with a lag, the pain of the lost liquidity to build over time — historically taking about 10 weeks to fully work through markets, BNP’s global head of macro strategy Sam Lynton-Brown and his colleagues wrote.
They project liquidity to fall as much a 9% by the end of September and up to 11% to wrap up the year. In a more extreme case, a contraction of global liquidity as large as 16% is likely, according to them.
“Global liquidity is an important driver of various assets,” Lynton-Brown said. “It therefore also impacts financial and monetary conditions. Rising global liquidity is likely one of the key reasons rate hikes in this cycle have had a smaller than had been widely anticipated impact on the economy.”
But “the wind is about to turn,” the BNP team said. “A tightening of liquidity may have a large impact on assets.”
Initially, government debt yields would rise, with the higher borrowing costs hitting other assets, BNP’s analysis shows. Later on, Treasury yields would likely fall amid haven-related demand.
