There has been a significant change in global liquidity conditions during the past six months or so.
Risky assets' outperformance over cash has stalled, or at least waivered, and volatility has increased across most asset classes. Conventional macro explanations for this shift, whether it's China or oil prices, have merit but it is important to consider what may prove to be an even more significant development - unorthodox monetary tightening, called quantitative tightening or QT.
QT can be seen as a counterpoint to quantitative easing and operates through multiple inter-related mechanisms at the global level. But in our view, QT occurs in two primary ways: changes in the composition of central bank balance sheets; and the depletion of foreign exchange reserves held by central banks and sovereign wealth funds. Some have even argued the case for a third; global regulatory tightening, largely as a response to earlier crises.
The first form of QT has been abundantly obvious in the US, where the start of a tightening cycle has seen a reduction of excess reserves in the banking system.
It's worth noting that negative interest rate policies, such as those adopted by the European Central Bank and Bank of Japan, can also be viewed as a form of unorthodox tightening. This in effect penalises the holding of excess reserves and the experience in Europe and Japan suggests that the policy will weigh on the financial sector.
The second form is when foreign exchange reserves are depleted. This also acts as a tightening of liquidity, both domestically and globally. Global reserves have been in decline since a peak around August 2014 but the erosion has been precipitous during the past six months, partly due the collapse in the oil price but also changes to China's currency policy leading to capital outflows.
There are other factors at play that serve as de facto tightening. One is the global regulatory response to the GFC and other recent crises. At an international level, entities such as the Basel Committee have issued a range of recommendations that act to constrain financial institutions' risk-taking. Sundry regulators at a domestic level are implementing multiple initiatives, profoundly impacting liquidity conditions and funding markets.
Cumulatively, these will act as a brake or headwind to otherwise accommodative monetary conditions.
The theory of QT first emerged from the analysis of global market volatility in August last year, coinciding with changes to China's currency policy and the rising expectations of a Fed hike in interest rates. The price reaction was consistent with a tightening in global liquidity conditions and, with the benefit of hindsight, this is now viewed as the transition point between the unchallenged regime of QE and the new paradigm of QT.
The accumulation of these QT forces is significant and seems likely to persistent, albeit less obvious than the more conventional monetary tightening underway in the US.
We believe that QT has the potential to be a macro dynamic influencing market conditions for the foreseeable future.