By Thanos Bardas
The markets are enjoying the central bank’s deliberate approach to balance sheet reduction.
Four years ago, the financial markets took the mere hint of monetary policy tapering as evidence that the sky was falling, and added 150 basis points to the 10-year Treasury yield before then-Fed Chairman Ben Bernanke said, “never mind.”
In mid-2017, the prospect of a reduction in the reinvestment of bond proceeds has been accompanied by a party in the capital markets, with stocks near all-time highs and Treasury bond yields remaining below 2.5%. Today, the FOMC confirmed what the market had anticipated: that it would hold off on raising short-term rates at least until December, while commencing a pullback of its balance sheet - at an initial maximum pace of $10 billion per month, before accelerating on a quarterly basis up to a cap of $50 billion per month within a year, split between Treasuries (60%) and mortgages (40%).
Although the committee declined to raise rates, most of its members anticipated another rate hike this year, while Fed Chair Janet Yellen suggested that further increases were likely in 2018 as well, given their confidence in the strength of the economy and the transitory nature of issues that are dampening realized inflation. Still, the group’s mean long-term rate estimate eased somewhat, from 3% to 2.75%.
The contrast between 2013’s meltdown and today’s feel-good environment is largely a function of economic conditions (stronger now) and the success of the central bank on jobs (with a 4.4% unemployment rate compared to the taper era’s 7.5% mark). Importantly, despite a muted immediate reaction, the market generally likes that the Fed is moving so slowly. At this rate, it will take three to five years for the Fed to normalize its balance sheet (if it chooses to do so), and the pace of rate hikes appears to have decelerated from quarterly post the U.S. election to twice a year on average over the next three years.
Calling the Tune
Not all FOMC members are in agreement about the interest rate trajectory from here; some are insistent that the Fed follow through on planned rate increases while others favor a wait-and-see approach. After five consecutive negative surprises on realized inflation, only the most recent print was a surprise on the upside. With trend inflation below target, we will likely need to see more such surprises for the Fed to move much further on rates, especially given an expected near-term slowdown in GDP growth tied to Hurricanes Harvey, Irma and Maria.
Part of the problem for the Fed is the current disconnect between inflation and unemployment, which the Phillips curve says should have an inverse relationship. Moreover, how can equity markets, credit spreads, corporate profits, consumer confidence and global GDP all experience such strong performance, whereas inflation numbers are so tepid? And how can realized volatility be so low and geopolitical risk be so elevated? Policymakers are scratching their heads as they try to investigate the linkage among inflation expectations, wages and the employment rate.
Fading Dance Party
What they do agree on is that the Fed should be reassuring and cautious as it moves into this new phase for monetary policy - hence Yellen’s insistence that the reduction of quantitative easing will be “like watching paint dry.”
That could be an apt description early on, as the Fed takes baby steps in allowing maturing bonds to roll off its balance sheet. But by late 2018 or early 2019, I’m not so sure. Withdrawals will be reaching critical mass while other central banks will likely be joining in to shed excess liquidity. In essence, there will be an acceleration of quantitative tightening, moving the combined global central bank balance sheets from a current growth rate of 8–9% to actual decline.
In recent years, global central banks have been sellers of volatility, protecting markets from the impacts of economic shocks via acquisition of credit assets, mortgages (MBS with imbedded options) and the most volatile fixed income securities such as long duration bonds. As the Fed moves away from selling volatility, and is later joined by its partners, the realities of a turbulent world will be far more evident in stock and bond prices.
So, rather than drying paint, think more of a fading dance party, which will take on a more rapid and irregular beat as revelers start to unravel. This year’s slow dance will eventually become last year’s fond memory, as investors look for a new tune to help improve the mood of the market.
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