Short and Sharp: And so it begins

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.



Follow Principal Global Investors on LinkedIn



Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of September 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision.

The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice.  Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.

Principal Financial Group, Inc.,  Its affiliates, and its officers, directors, employees, agents,  disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document. 

Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments.  Principal Global Investors does not endorse, authorize, or sponsor any third party content.  Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided

​Investing involves risk, including possible loss of principal.

Insurance products and plan administrative services provided through Principal Life Insurance Co. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities offered through Principal Securities, Inc., 800-547-7754, Member SIPC and/or independent broker/dealers. Principal Life, Principal Funds Distributor, Inc. and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392.