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Article: As Central Banks Taper, Investors Should Take Cover

Do you have too much money? Losing sleep over that ballooning bank account? Perhaps not. But spare a thought for Jerome Powell and Christine Lagarde, who must lead us all out of a global monetary glut. Facing essentially the same pandemic-era problem, the Federal Reserve and the European Central Bank have come to the same solution: drastically cut monthly net asset purchases. Unfortunately for financial markets, they will be pulling back at the same time, setting up 2022 as the year of the "taper tandem"the fastest liquidity drain in a decade.

Monetary data indicate that advanced economies are awash in money, thanks to central banks' voracious buying of financial assets. In March 2020, amid financial panic over Covid-19, the New York Fed was creating money to buy up to $75 billion of assets every day. Around the same time, the ECB announced an emergency program targeting 1.85 trillion ($2.15 trillion) of purchases in total. Plentiful liquidity helped governments, businesses and households survive lockdowns. Cash flows collapsed but bankruptcies barely increased. Asset markets and the real economy exited the crisis on a strong footing.

The Covid public-health crisis seems to be abating, but the infusion of money never stopped. The two central banks are still buying roughly $235 billion of assets every month between them. Because neither the U.S. nor the EU has capital controls, this additional liquidity flows freely across borders, flooding markets everywhere. For global liquidity, it does not matter much which of the two central banks is doing the purchasing.

The result has been a feverish rally in nearly all assets, suppressing borrowing rates, inflating stock prices, and even creating assets where none existed. The financial system is having to invent new kinds of assets because not enough exist to absorb the deluge of central bank liquidity. More than 6,000 cryptocurrencies are now being traded, not to mention nonfungible tokens, which supposedly establish ownership of easily copied digital artworks.

With inflation picking up, the central banks are reining in purchases. The ECB has already begun, announcing a move to a "moderately lower pace of net asset purchases." The Fed essentially promised to do so this quarter, warning markets that "a moderation in the pace of asset purchases may soon be warranted."

In two respects, the key term here is "moderate." First, it reveals the banks' concern that markets will react too abruptly to the policy change. Second, it is untrue. The two banks' combined net purchases are scheduled to go from the current pace of about $235 billion a month to zero in 12 months, a deceleration of about $20 billion a month.

The last time net purchases were reduced in the U.S., setting off the "taper tantrum" of 2013-14, the Fed's deceleration pace was $8.5 billion a month over 10 months. But at the time, the ECB was gearing up to start its own purchases, providing markets with a counterbalance. When the ECB implemented its own taper in March 2017, it took 21 months to complete it, decreasing net purchases by an average of 3.9 billion a month. The snail's paceand the ECB's resumption of net asset purchases 11 months laterhelped counterbalance the net sales of securities by the Fed.

In both these episodes, the two central banks offset each other's impact, damping the aggregate effect. This time, however, the two banks are set to taper in tandem, amplifying the effect on money flow. This should terrify investors. Recent pioneering research by Xavier Gabaix and Ralph Koijen shows that flows not only move asset prices; they move them disproportionately. A dollar added to the stock market can increase aggregate market valuation by as much as $5. A dollar subtracted can have the opposite effect, decreasing aggregate valuation by $5.

No flows are more sizeable or more predictable than a big central bank's purchase schedule. As the world's two major central banks prepare to turn off the taps, financial markets are on notice. Frontier assets such as NFTs will likely be the first to fallbut experience suggests that no asset class is safe from a liquidity drought. As the taper tandem unfolds, investors and asset managers will need all the downside protection they can get.

Mr. Valatsas is chief economist at Greenmantle, a macroeconomic and geopolitical advisory firm.

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