Central Bank ‘Punch Bowl’ Still Brimming for Markets

LONDON, Feb 19 (Reuters) – Central bank support forpandemic-hit economies looks to endure well past the recovery inoutput, leaving investors little option but to keep chasing aparabolic bull market until the fabled “punch bowl” iseventually removed.

William McChesney Martin – the longest serving FederalReserve chief between 1951 and 1970 – is credited with thefamous quote about the Fed’s main job being to “take away thepunch bowl just as the party gets going” – or tighten creditonce the economy recovers from recession.

But an assumption his maxim will now be flouted to morefully reflate the economy after the COVID-19 shock is alreadystoking stock bubble fears and not a little angst about a returnof inflation akin to the one which emerged in the decade afterMcChesney Martin departed the central bank.

This week’s minutes from the latest policymaking meetings atthe Fed and European Central Bank did little to shift that view.

“Trying to time a market bubble wouldn’t normally be a goodidea. But the near-explicit endorsement of the price action bythe Fed leaves investors with little choice,” said Citi’s globalmarkets strategist Matt King.

But just how much punch is still in that bowl – or indeedhow much more is still being poured in?

Bank of America’s monthly investor survey this week showedglobal fund managers were now almost fully invested, reportingthe lowest cash positions since just before the Fed first mootedtapering its post-banking crisis bond purchases in 2013.

More alarming was that as few as 13% of them saw record highworld stock markets and valuations as a bubble – even throughMSCI’s all-country index is already 20% above pre-pandemiclevels and has almost doubled since last March’s trough. Thefroth in everything from Big Tech to cryptocurrencies, pennystocks, unprofitable startups or blank-cheque funding vehiclesdoes not seem to deter anyone yet.

One reason is that, far from being removed, the punchbowl isgetting routinely refilled.

THE DEVIL’S PUNCHBOWL?

Although percentage cash levels held by investment managersare falling, they are not falling fast enough to keep up therapid expansion of money still flooding the system.

With total assets under management of $4.3 trillion,cash-like U.S. money market funds still hold some $700 billionmore than pre-COVID levels – more than $300 billion above thepeak of the banking crash.

U.S. household savings at the end of 2020 were still almost$1 trillion above pre-COVID levels, with U.S. M1 and M2 measuresof annual money supply growth – covering banknotes, checking andsavings accounts – running at almost 70% and 26% respectivelylast month. Data in Europe is more lagged and less extreme butshows a similar picture and no let up.

An 6% jump U.S. ‘core’ retail sales last month is anotherway to view it – by revealing the instant impact of the $900billion yearend government support package and the $600 stimuluschecks mailed out.

And that’s all before the new administration of PresidentJoe Biden passes its planned $1.9 trillion stimulus plan, withadditional household support checks likely part of it.

This month’s inflation warning from ex Treasury SecretaryLarry Summers stressed the Biden plan means $150 billion a monthfor a year into an economy growing at a pace exceeding 6% -where the ‘output gap’ from pre-pandemic potential is officiallyestimated to shrink to $20 billion a month by 2022.

But how all this mechanically affects asset prices may getcloser to explaining near frenzy in markets of late.

Without tapering its bond buying or halting its balancesheet expansion – and few now expect that this year – the Fedwill be adding $120 billion a month in bond purchases, in partto keep all the new government debt affordable.

But Citi’s King reckons that a reversal over the comingmonths of a peculiar surge in the Treasury’s General Account atthe Fed last year – as new government debt was sold but notspent – could fuel the fire by inflating Fed bank reserves.

If Fed bond buying via creation of bank reserves is the realdriver of market pricing, King argues, then the expected $1-1.5trillion rundown in the TGA over the coming months could triplethe $120 billion a month of bank reserves now being created.

The TGA ballooned last year by about $1.5 trillion betweenMarch and July and now stands at $1.58 trillion – far in excessof an average of about $350 billion over the prior two years.

King sees it as almost “negative QE” – only masked by aparallel $3 trillion of Fed quantitative easing last year. Itslooming drain may have the opposite effect that superchargesmarkets already awash with liquidity and pushing short-term billrates to the floor even as bond yields rise.

Others downplay the issue. TD Securities strategistsclaiming the only time it makes a difference to risk assets isduring a ‘reserve scarcity’. The effect will be limited tosuppressing money market rates and the Fed can adjust rates onexcess reserves to manage that.

But King doubts there’s smoke without fire.

“The only real debate seems to be whether this is just anissue for money market nerds, or whether it has system-widerelevance,” he said. “Both a long-standing conviction thatmoney-market plumbing has an underappreciated significance, andsome additional empirical evidence, make us suspect the latter.”