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Years of reform failed to alter rating agency business models blamed for crisis Crisis put Goldman, Morgan Stanley on journey into bankland Yield-seeking Japanese banks exposed to Chinese risk Risk averse banking sector could facilitate a snapback in debt markets Fed edges closer to decision on its supersized balance sheet
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The withdrawal of central banks from the debt markets is set to shift the flow of global capital as previously compressed spreads widen, leading to concerns that heavily indebted U.S. corporates as well as emerging-market economies will be exposed to a sharp rise in borrowing costs.
Net liquidity from central banks — primarily at the U.S. Federal Reserve, Bank of England, European Central Bank and Bank of Japan — is at its lowest level since the financial crisis, according to the Institute of International Finance, a financial industry trade body. The U.S. Federal Reserve's quantitative tightening has shrunk its balance sheet to $4.2 trillion from a high of $4.5 trillion in 2015, and central bank liquidity globally will reduce further as the ECB, the BoE and the Bank of Japan wind down their own asset procurement programs.
The collective balance sheet of central banks peaked in March, according to Wells Fargo Securities, and the bank expects the Fed’s balance sheet to bottom out at just below $3.7 trillion in late 2019 or early 2020.
Quantitative easing, or QE — the process of central banks buying securities — was designed to boost economic growth and encourage borrowing by suppressing interest rates. As central banks pull out of the markets, yields that had been pressed artificially low have rebounded.
Analysts note that some of the less liquid debt markets, particularly emerging-market economies and the U.S. corporate sector, could experience a more dramatic snapback in borrowing costs, potentially sparking a chain of defaults. "We will end up in an environment where there is less global liquidity and the impact will be on riskier assets," said Emre Tiftik, IIF deputy director.
Surging borrowing costs among emerging-market economies have been making the headlines, as the market reprices the risk that countries such as Argentina and Turkey will be unable to repay their substantial foreign debt obligations. In its August outlook, rating agency Moody's said emerging-market countries are "inherently vulnerable to the risk of capital outflows associated with tightening global liquidity." Net portfolio inflows into emerging markets fell sharply in August to $2.2 billion, down from $13.7 billion in July.
But Tiftik argued that U.S. businesses are also at risk from a sharp scaling back of demand for debt. "This is not just an emerging-markets story. U.S. corporate debt is also close to the all-time high," he said.
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Corporate creditworthiness has declined as a surge in M&A activity has left a substantial chunk of corporates rated a notch above junk status. "There are weak spots such as small caps, highly indebted firms. In the U.S., there are excess amount of cash flows but who holds it? Large firms. They have large debts, they have large cash holdings, but, if you look down the sector, they have large debts but not enough cash," Tiftik said, noting that such companies "will either default or, if possible, they will borrow more."
The $11 trillion of corporate debt globally rated by S&P Global Ratings is due to mature by the end of 2023. "Given the long window between now and the year of peak maturities, credit markets are likely to experience a period of heightened stress within that time frame," wrote S&P’s fixed income team led by Diane Vazza.
How far will yields rise?
Geopolitical uncertainties have held back yields in the U.S. as investors pile into traditional safe havens such as U.S. Treasurys. "The focus now is emerging markets, so rates on Treasurys are below 3%. But, once they're more positive on emerging markets, U.S. rates will go up and then there will be a new focus," Tiftik said. JPMorgan Chase & Co. Chairman and CEO Jamie Dimon speculated that 10-year Treasurys will hit 5% as the Fed continues to raise rates and Treasury issuance increases to cover the growing debt burden.
The ECB has bought €2 trillion of sovereign bonds since it began its QE program, while net outflows from the eurozone have reached €1.5 trillion as investors poured into U.S. bonds. Fitch Ratings noted that eurozone investors now hold as many U.S. bonds as Japan and China combined but, as the ECB tapers, yields in Europe will rise and investors will likely redirect capital to domestic markets.
"This large net capital outflow has likely helped cap benchmark long-term bond yields in the U.S. and elsewhere, and a reversal of these flows could drive yields upwards," wrote Brian Coulton, Fitch's chief economist.
According to Tiftik, the limited depth of the European debt markets will mean capital will have to go elsewhere, such as debt-hungry China. "There will be a decline in outflows from Europe but it still has to go elsewhere. Most of the big institutional investors in Europe have difficulties [finding] 'investable' projects; this was the main trigger pushing down the emerging markets," Tiftik said.
The increased cost of hedging currency risk has already resulted in Japanese investors pulling out of U.S. Treasurys, according to Robeco portfolio managers Olaf Penninga and Johan Duyvesteyn, and with the Bank of Japan allowing yields to rise in its domestic bond markets, Japanese investors are likely to withdraw further from their international exposure.
International investor holdings of U.S. corporate bonds have been near all-time highs, at 29% in the first quarter of 2018, but that number is declining. "Recent fund flow data also indicate that demand, including that from U.S. investors, has waned, with inflow volumes down 30% year over year," Macquarie's fixed income credit team wrote in August.
Extent of the shock
Capital flight from the U.S. could be tempered by the extent of the Fed’s monetary tightening. S&P wrote that a further four rate hikes in the next year would widen yields on U.S. and European corporate debt further, "which could hamper investor interest in European assets over time, particularly when combined with the strengthening dollar."
A reduction in debt issuance could also hold back yields. Tax reform in the U.S. has reduced the incentive for companies to hoard cash offshore and companies are repatriating cash to pay down debt.
S&P Global Ratings and S&P Global Market Intelligence are owned by S&P Global Inc.