Photographer: Scott Eells/Bloomberg

What Does the ‘Wall of Money’ Mean for Your Investments?

As central banks raise rates and dial back stimulus programs, a bit of digging may provide some clues about what happens next.

Whether stocks, bonds, real estate, or art, asset prices were either at record levels or heading higher. Some commentators say this is because central banks—seeking to fight off a full-fledged meltdown—unleashed so much cash into the financial system that we’ve built a gigantic “wall of money” searching for yield.

A couple of suggestive data points: Go to {FED <GO>} on the Bloomberg terminal, click on the Balance Sheet and Security Purchases button, and select Fed Balance Sheet. You can see how the Federal Reserve’s quantitative easing—which aimed to push down longer-term interest rates by buying bonds—swelled its balance sheet. Next, add up the balance sheets of the Fed, the European Central Bank, the Bank of Japan, and the People’s Bank of China, and you get a total of more than $20 trillion. That’s equivalent to about 22 percent of the world’s total outstanding bonds or about 25 percent of global equities. It’s a lot of money.

Amplified through the financial system, the theory goes, the wall of money will jump in and bid up the price of an asset every time it drops in value. Low volatility conundrum? Voilà! The wall of money. The wall of money is either a sweeping narrative that has the potential to explain much of what’s happening in financial markets, or it’s an oversimplification of a complex process that’s not fully understood—perhaps even by central bankers. (It depends on whom you talk to about that.)

Nevertheless, digging into what’s happening may at least provide some clues about what could come next as central banks raise rates and remove stimulus programs. One theory focuses on inflation, interest rates, and something called the term premium.

What’s the term premium, again?
Sovereign bond yields, according to basic economic theory, can be decomposed into two main components: the expectations about how short-term interest rates will evolve and the compensation that investors require to take on the risk of holding longer-­term securities, which is known as term premia.

The term premium, of course, isn’t directly observable, but there are ways to tease it out from the yield curve. Economists Tobias Adrian, Richard Crump, and Emanuel Moench came up with one approach a couple of years ago, when they were all at the Federal Reserve Bank of New York. Their estimates of term premia, called ACM from their names, are now available on the terminal. To chart the estimated term premium for 10-year Treasuries, for example, run {ACMTP10 Index GP <GO>}.

With interest rates and inflation low—and QE reducing the risk of holding longer-term fixed-income securities—the term premium is negative across all maturities of Treasury securities. That’s weird: It’s like you have to pay to take the risk that rates don’t evolve as expected. OK. Wall of money, right?

But what can that mean?
The term premium can be further broken down into two components: first, the risk that inflation might not evolve as expected; and second, the risk that the neutral real rate of interest might deviate from expectations already built into the yield curve. The real rate risk premium, according to Bloomberg calculations, has been trending lower since 2014 and ran negative for most of 2017.

To compare the term premium with the 10-year Treasury yield, run {ECWB <GO>} for the Economic Workbench function. Click on Create Chart, give the chart a name, and then click on Create. Select 1 Year. To chart the generic 10-year Treasury yield, enter “GT10 Govt” in the field and click on the matching item. Next, to add the term premium, enter “ACMTP10 Index” and click on the match.

What does this show?
In 2017 the yield tracked the term premium lower until September, when inflation and rate expectations started to trend higher. Investors are pricing in the prospect of the Fed continuing its process of normalization, with higher policy rates pushing yields up at the front end of the curve and the drawdown in its bond holdings doing the same at the long end of the curve. The yield is now tracking inflation expectations more closely than the term premium.

It reflects an environment of lower-trending real risk premia and higher-trending inflation expectations. That should encourage investors to put money into assets that will deliver excess returns. Simply put, the market is telling investors that the risk of loss is low, but the risk of inflation is higher. Investments are less likely to lose. Cash holdings are under threat from higher inflation.

Yields on 10-year Treasuries tracked the term premium lower until September.
Since September, though, yields have more closely reflected inflation expectation risk.

So what could happen next?
If the real risk premium remains negative with contained inflation risk, stocks and bonds can continue to deliver positive returns. However, if the real risk premium moves higher, into positive territory, bond yields may move to slightly higher levels than forward rates, delivering low to negative returns. You can see that in the swap market, which is pricing 10-year rates to be only slightly higher than now. Much higher than that would be unlikely, considering debt levels and the go-slow approach the Fed is taking. Equities may continue to benefit, with slightly higher volatility.

What could make the wall of money crumble?
Any activity that would cause a rapid rise in the real risk premium. The danger point could come if all private and central bank balance sheets become fully levered. Should that happen, asset prices would drop, or governments could try to devalue their currencies. Nowadays, it looks as if such a point—should it come—would be a decade or more away. There’s still room to run in the balance sheets of most major central banks, and corporates and consumers aren’t maxed out with debt. Fiscal policy in key countries such as the U.S. that lead to large budget imbalances could change that situation, though. Other risks include corporations issuing debt to buy nonproductive assets and the combination of low savings rates and aging demographics forcing early and rapid asset sales.

The other possibility is that central banks aggressively increase rates or reduce the size of their balance sheets, forcing risk premia higher and asset prices lower. It’s actually quite easy to do. All that’s needed is one or two hikes too many—or a reduction of a few billion dollars in asset purchases—to cause harm to the economy. In such a complex system, it’s hard not to see some policy mistakes.
With Michael Rosenberg and Robert Lawrie

Leininger is a derivative and fixed-income market specialist at Bloomberg in New York.

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