The Fed announced the start of balance sheet reduction at its 20 September meeting and noted it will begin implementing it in October. The ECB is about to announce a reduction in its net asset purchases volume on 26 October and to probably end its net asset purchases in second half of 2018. In addition, BOJ asset purchases have fallen and continue to fall due to its yield target regime. Overall, advanced economy net asset purchases are likely to fall from 100 billion month to zero by end of 2018.
Tapering may trigger corrections
The footprint of central banks in financial markets is very large. The combined asset holdings of the five central banks with recent QE programs amount to 11.5 trillion, 26% of the outstanding values of those asset classes. The decline in central bank net asset purchases will lead to a rise in net supply of the assets that central banks were previously buying. Lack of enough substituted demand, asset price will fall.
Central Bank Net Asset Purchases (3MMA, $Bn)
Data source: Central bank; Citi
Our concern is that global taping will lead to higher implied and realized volatilities. Increases in volatilities can turn out to be self-reinforcing, as rising realized volatility can induce investors to try to exit their position, which in turn lead to further price correction and higher volatilities.
Tapering may not matter after all
The details of Tapering have been widely anticipated by the markets. Many surveys indicated a very high probability for Fed balance sheet reduction this year. And the respondents also expect ECB will reduce the asset purchase amount. If markets are orderly and efficient under proper central bank forward guidance, the changes in net asset supplies should be absorbed easily.
On the other hand, the change in central bank purchases is mostly due to better economic conditions. Central banks will tread carefully and the direct of global tapering on the real economy will be modest. We believe some factors could stop or delay global tapering, including a major financial tightening, economic slowdown and low inflation. Last but not the least, any major changes in central bank leadership, such as Fed, will also affect the direction and speed of tapering.