Almost nine years after beginning its balance sheet expansion, the Federal Reserve (Fed) has taken the first step toward unravelling this extraordinary crisis measure. Alongside this momentous (if understated) policy move, the Fed signalled that despite low inflation it still intends to raise policy rates once more this year, and three times next year. Does this spell trouble for asset markets?
Investors are right to feel slightly anxious about central bankers finally taking away the punch bowl. After all, the impact of the Fed’s balance sheet reversal is uncertain. But I take some reassurance from the fact that normalization has been well telegraphed, and has triggered minimal market reaction – until now at least.
Normalization is also set to be quite gradual. The announced details suggest that the balance sheet size is unlikely to fall below $4 trillion before the end of 2018 (from around $4.5 trillion currently and compared to about $0.85 trillion before quantitative easing started). The slow pace will probably mute the market impact and allow the balance sheet reduction to run quietly in the background.
In fact, the combined balance sheets of the Fed, European Central Bank (ECB), Bank of England (BoE), and Bank of Japan (BOJ) will probably continue growing in the first half of next year. The BoJ’s balance sheet will still expand in 2018, as will the ECB’s (albeit at a slower pace), and together they should more than offset the Fed’s balance sheet reduction. As a result, global risk markets will continue to be flooded with liquidity.
Of course, it isn’t just the Fed’s balance sheet unwind that investors are nervous about. In recent weeks, the Fed, BoE, and Bank of Canada have all signalled to markets that interest rate expectations are too low.
But while markets have been surprised by central bankers’ confidence that inflation will return to target, policy rates are still likely to rise at a snail’s pace. According to the Fed’s own projections, the fed funds rate is likely to only reach 2.1% by the end of 2018, and just 2.9% by the end of 2020. The ECB is not likely to raise policy rates before 2019, while the BoJ Governor has recently commented that there could even be a need for further monetary easing. Global monetary conditions, and therefore financial conditions, are likely to remain very accommodative for the foreseeable future.
Gentle monetary tightening means that risk assets can continue to perform positively, and I would remain overweight both equities and credit. Of course, valuations are undoubtedly tight across markets. But the combination of solid growth, easy financial conditions, and low volatility is a backdrop that can support current valuations, at least until year-end.
One market that usually responds negatively to Fed tightening is emerging markets, because they are vulnerable to capital outflows. However, strong global growth equals strong global trade, and is therefore very supportive for emerging economies, while improved policy-making has made them more resilient. Furthermore, Fed tightening is typically not a problem until the end of the monetary cycle. As a result, while I would not recommend adding to exposure given the likely U.S. dollar stabilization/bounce, I suspect that emerging markets can handle the Fed’s historic policy shift.
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