The Central Bank Put came to the rescue in 2020, 2021 brings new Challenges

Central Banks are rightly credited with stabilizing bond markets earlier this year in large part through unprecedented amounts of liquidity creation. Compared to the Global Financial Crisis, this time we saw much lesser interest rate cuts but significantly more balance sheet expansion. 

It is important to note that a Central Bank Balance sheet is not necessarily a good proxy for the stimulus provided to the economy. Different Central Banks are purchasing hugely different maturities and hence not extracting the same amount of duration. Most Fed purchases have been at the front end of the curve (60% is <5y maturities), so those purchases are worth about half that in 10y equivalent duration terms. This point is especially important to track as markets expect the Fed to do some ‘Yield Curve Control’ going forward given the recent rise in far-end rates which can give rise to yield curve steepening.

Active Central Bank asset purchase programs have ensured that financial conditions have tightened much less than during the Global Financial Crisis. Credit stress has been contained. This has prevented Bankruptcies and widening of credit spreads. 

We expect unwind of Central Bank support to be slow and gradual particularly for the Fed and ECB. Central Banks would want to prepare markets much in advance to avoid a repeat of 2013 Taper tantrums.

Inflation – Potential fly in the ointment?

Most market participants are convinced that the world will still have large spare economic capacity i.e., a negative output gap in 2021 which rules out Inflation as a near term headwind especially in the developed markets of US, Euro zone, UK, and Japan.

However, the conviction on the inflation outlook looking beyond 2021 is significantly lower. Inflation surge as early as 2022 could be the top risk facing the world economy and forward-looking financial markets especially when everyone is complacent about it. The biggest factor which has the potential of driving Inflation is the turning of the Commodities Cycle 

Markets may start pricing in the Inflation risk later sometime in the second half of 2021.