The return of quantitative easing

The writer is managing director at Crossborder Capital and author of ‘Capital Wars: The Rise of Global Liquidity’

Rising world stock markets appear to confirm that global liquidity — the pool of cash and credit shifting around financial markets — is once again expanding after skidding lower last year.

So much then for central bank quantitative tightening, the much-mooted unwinding of the massive stimulus programmes to support markets and economies.

Our estimates show that the liquidity cycle bottomed during October 2022, in the wake of former UK prime minister Liz Truss’s “mini” Budget debacle, and looks set to trend higher over the next few years. Investors should therefore expect a continuing tail wind from global liquidity instead of last year’s severe headwinds. This should prove good for stocks, but less positive for bond investors.

Britain’s gilt sell-off last autumn gives us a foretaste of future challenges for sovereign debt markets and points to some coming hard decisions for both policymakers and investors. The integrity of banks and sovereign bond markets are sacrosanct in modern finance. Led by the US Federal Reserve, central banks have just injected substantial cash into money markets over recent months helping to bailout flaky banks. But in coming years they will probably have to bailout debt-burdened governments, too.

In short, markets need ever more central bank liquidity for financial stability and governments will need it even more for fiscal stability. In a world of excessive debt, large central bank balance sheets are a necessity. So, forget QT, quantitative easing is coming back. The pool of global liquidity — which we estimate to be about $170bn — is not going to shrink significantly any time soon.

The promised fall in the size of the US Fed’s balance sheet has been far from convincing. Falls in direct bond buying have been offset by other Fed liquidity-creating programmes such as short-term lending to commercial banks. A rundown of the Treasury General Account, the government’s cheque account at the Fed, and small withdrawals of deposits at the central bank have also contributed.

On top of this, the US Treasury is debating buybacks to improve bond market liquidity, targeting sales of bills to money market funds and is likely to reduce the average duration of Treasuries available for private investors to boost demand. All will help to boost global liquidity. Expect more of these unconventional policy twists in the future.

The past two roller-coaster decades have shown how financial markets need liquidity to rollover the vast debts built up by corporations, households and governments. We estimate that a whopping seven in every eight dollars changing hands in world financial markets are now used to refinance existing debts. An increasing share of the one dollar leftover for “new” financing is applied to fund swelling government deficits.

Looking ahead, the advanced economies face renewed pressures on public finances as military requirements and demographics boost mandatory spending, while the tax base is compromised by larger numbers of retiring high-wage workers. On top, international tax competition probably rules out substantially higher marginal rates.

Consider US fiscal math. The US government will need to sell an average of $2tn of Treasuries each year over the next decade. And according to latest Congressional Budget Office forecasts the Fed will be required to chip in.

The CBO estimates that Fed holdings of US Treasuries will have to rise to $7.5tn by 2033 from current levels of nearly $5tn. No QT here, but worse, these CBO spending projections are likely too low — especially for defence outlays. More realistic numbers point to required Fed Treasury holdings of at least $10tn. That translates pro rata into a doubling of its current $8.5tn balance sheet size and will mean several years of double-digit growth in Fed liquidity.

Looking around, there are not many alternatives to this Fed QE. Mandatory spending is effectively already set in stone and tax bases have been squeezed dry. Foreigners hold about one-third of US debt, with China still a major investor, but growing geopolitical tensions will probably reduce their appetite.

How about domestic US households and pension funds? The trouble here is that higher interest rates may be required to entice them into bonds especially when the threat of monetary inflation looms large. Yet higher interest rates boost the fiscal deficit, requiring still greater amounts of debt, thereby compounding the problem. As they joke in Ireland, if you want to travel to Dublin, don’t start from here.