Revisiting The Only Thing That Matters In A Taper: Stock Vs. Flow Effects

With the ECB decision in the books, it’s worth briefly revisiting the QE “stock” versus “flow” debate.

Although you can add specificity and fancy language if you like, it boils down to a very simple question: is it the cumulative size of central bank balance sheets that matters (the stock effect) or is it the pace of the ongoing purchases (the flow effect) that’s important?

As a reminder, no one knows the answer to that yet. That’s how it works with things that are “unprecedented” like the post-crisis monetary policy response. When you do something unprecedented, you have no idea what’s going to happen when you undo it, because, by virtue of that thing you did being unprecedented, the undoing of that thing is by definition unprecedented too. Here’s what Deutsche Bank wrote a couple of weeks ago:

We are likely to be nearing a low point for major market bond and equity vol, and if the catalyst is policy it will likely come from positive volatility QE ‘flow effect’ being more powerful than the vol depressant ‘stock effect’.

Ok, so that’s the lens through which you might want to look at the ECB taper. Here are a couple of excerpts from a Goldman note out Thursday evening:

The ECB’s QE affects bond yields through three interlinked channels. A ‘stock effect’, by which the cumulative amount of long-dated bonds owned, and reinvested, by the central bank shrinks the stock available to private investors and acts to depress the term premium. This effect is amplified in countries, like Germany, that have comparatively lower debt, and little net supply. A ‘flow effect’, as the more regular and predictable is the amount of secondary market purchases conducted by the national central banks, the lower the amount of duration risk dealers are asked to absorb when they underwrite government securities in the primary market. This effect is particularly important in countries where sovereign credit risk is higher. And a ‘forward guidance booster effect’: as long as net central bank purchases are running, investors do not expect the central bank to hike policy rates.